Quarterly Newsletter - 4th Quarter, 2013
PERIOD FMR* Taxable FMR* Retirement S&P 500 DOW Russell 2000
1st Qtr +11.98% +6.50% +10.61% +11.92% +12.03%
2nd Qtr +0.43% -2.26% +2.90% +2.91% +2.73%
3rd Qtr +0.32% +0.33% +5.24% +2.12% +9.85%
4th Qtr +5.81% +4.16% +10.51% +10.22% +8.72%
YTD +19.43% +8.81% +32.39% +29.65% +41.70%

    Euphoria reigned supreme as the market closed out 2013 with yet another new high on the S&P 500 of 1848, +32.4% for the year. At the last minute, the House and Senate passed a very small budget compromise, and the Federal Reserve finally announced it would begin a small reduction in its government bond buying program in January. Our best estimate, assuming a functioning fiscal environment for 2013, was 1760, +23%, and we gave that only a 25% probability. Fortunately, we do not spend more than 1% of our time trying to forecast how the stock market will perform, and we are not obsessed with trying to beat a specific market index over any short time interval. 

    Our principal objective and focus is to generate capital gains from companies who pay significant dividends that keep growing year after year without dividend cuts. We fully understand that lower risk “dividend generous” stocks do NOT outperform the broad market in red hot years like 2013. Importantly, Five Mile’s income/growing dividend objective should provide an income stream growing at 5% to 10%, easily exceeding the expected inflation rate. This lower risk, less volatile strategy should outperform during corrections and future bear markets, while providing both capital gains and additional income. For long term planning our forecast for equity returns is +8% to +9%, consistent with equity returns over the past fifty years (9% annual growth doubles a portfolio in eight years). 

 What is behind this 30%+ market return and is the stock market overvalued? There are two parts to the stock valuation question, the earnings of the S&P 500, and what we call the P/E ratio (the stock price divided by the earnings per share of the company or in this case the index). Since the end of 2011, the earnings of the companies that make up the S&P 500 index are only up about 6%, as this has been the slowest economic recovery from a recession in 50 years. However, the P/E ratio has been the key metric in 2013’s above average stock market performance. This ratio expanded from 13 to 17 ($1 of earnings was worth $13 in 2011 and is now worth $17 at the end of 2013). The 2013 S&P 500 index closing price of 1848 divided by estimated 2013 earnings of $109 equals 17. Is 17 too high? The answer is no, we believe that while the stock market is no longer undervalued, a price/earnings multiple of 17 times is reasonable in our low interest rate and low inflation environment. 

   Why? The median P/E since 1989 is 17.8x, and today’s valuation has returned to a ‘normal’ level looking back over this 25 year period. If you go back to 1946, the median P/E was 15.8. However, the vast majority of companies in this broad market index of 500 companies are more profitable today than they were before 1990. Their return on equity (key measure of a company’s profitability) is higher, which means they are generating more “free cash flow.” We define this metric as the excess cash after what is necessary to run the business, after dividends and capital expenditures. This is one of the key metrics we use to identify companies for our portfolios.  

 Ninety percent of our portfolio companies generate free cash flow. Thus they are able to reward shareholders with growing dividends and stock buybacks, which cushion Five Miles’ holdings should interest rates rise. In 2013 Five Miles’ investments demonstrated noticeably strong dividend growth: General Mills +15.2%; General Electric +15.8%; Kinder Morgan +13.9%; Johnson and Johnson +8.2%; Proctor and Gamble +7%; Philip Morris +10.6%, UPS +8.8%; Weyerhaeuser +18%, to name a few. Stock buybacks have the effect of supporting the stock price and reduce the shares outstanding, thus increasing the reported per share earnings. U.S. companies bought back an incredible $750 billion of their shares in 2013. This was an obvious contribution to the S&P’s record advance since this dollar amount represents approximately 5% of the total value of all equities! 

 Over the last three years of this weak recovery, corporate revenue growth has been very modest at 1% to 3%, however, the 6%+ earnings growth was attributable to the expansion in profit margins and thus free cash flow. The margin expansion has risen largely because productivity has risen. The widespread deployment of technology has been a major contributor to this rise in productivity. In addition, margins have benefited from the reduction in interest expense on corporate borrowings, and the restraint in labor costs. With profit margins for the S&P 500 back to record levels, it is difficult to argue that managements can squeeze more labor cost savings from this level (you can only fire “Fred” once). Therefore, if we assume margins hold at these levels, earnings growth for the S&P 500 will be largely determined by the growth in corporate revenues. When the Fed announced it would dial back or start to taper the purchase of bonds (Quantitative Easing or QE) it reasoned that the economy was showing signs of positive momentum, citing improvement in retail sales, housing, and employment. This will translate into corporate revenues growing as well, propelling S&P 500 earnings to advance 5% to 6%, or $115. Whether S&P earnings can advance to $125 in 2015, or 9% above 2014 estimates, will not be clear until the second half of this year, at the earliest. 

 As most investors know, it has been more than two years since the stock market has experienced any corrections of 10% or more. One concern for some investors has been the specter of interest rates rising too rapidly following the FED scaling back its government bond buying program (QE). While the repression of interest rates by the FED has been only marginally successful at boosting economic growth and underemployment, it has had a “wealth effect” through the stock market recovery. Will there be unintended consequences resulting from the winding down of QE, and the likely rise in rates? Will our new Federal Reserve Chair, Janet Yellen, simply hold the massive $4 trillion dollar portfolio of QE purchases, or does she begin liquidating? The stock market rallied strongly on the FED announcement of tapering its bond buying, all the while yields rose on the Ten-year Treasury Bond from 2.5% to 3%. In the absence of any QE, we estimate that a normalized yield on the Ten-year Treasury Bond would be in the range of 3.5% to 4%. If this takes place over the next two years as we expect, it may slow the housing recovery, but is unlikely to stop it, or derail our modest economic recovery. While in all likelihood, the market has begun to discount the exit from an unprecedented period of low interest rates, this should not be disruptive to the economy or the market as long as the interest rate increase on the Ten-year Treasury Bond occurs at a measured pace. The FED also indicated in its December announcement that they would continue to keep short term interest rates low through 2015. With bonds and cash providing very low or non-existent returns, it is not surprising to see investors seek better returns in equities instead of long-dated bonds. 

 While we are easily disabused of trying to forecast the stock market for 2014, what we do believe is that the stock market is not vulnerable from severe overvaluation. It is important to emphasize that big up years like 2013 are often followed by positive stock market years. Nevertheless, higher risk sectors in the market may be subject to a correction. It would not surprise us if this reasonably valued stock market was flat to up 5% for 2014. In a Camelot scenario, the S&P 2015 EPS of $125 could be valued at the current 17 PE which translates into a market rise of 15%! The stock market is not close to the bubble environment of the late ‘90’s, and it is still possible to find solid and reasonable values. The most important good news is that our value focus on free cash flow and dividend growth gives us the luxury of not playing the short-term stock market momentum game. Growing dominant free cash flow businesses with managements committed to rewarding long-term shareholders remain our principal business. 

    We wish you a Happy and Healthy New Year.


Lee                                        Todd                                        Martha                                   

The performance information above *  is not audited and has not been otherwise reviewed or verified by any outside party.  While Five Mile River Investment Management, LLC endeavors to furnish accurate information, investors should not rely upon the accuracy or completeness of this information.

This letter is not meant as a general guide to investing, or as a source of any specific investment recommendation, and makes no implied or express recommendation concerning the manner in which any client's accounts should or would be handled as appropriate investment decisions depend upon the client's investment objectives.  Any offer to sell or the solicitation of an offer to buy any interests in any securities may be made only by means of delivery of a Five Mile River Investment Management Agreement and or other similar materials which contain a description of the material terms and various considerations and risk factors relating to such securities or fund.  Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be either suitable or profitable for a client's or prospective client's portfolio, and there can be no assurance that investors will not incur losses.