Quarterly Newsletter - 1st Quarter, 2014
PERIOD FMR* Taxable FMR* Retirement S&P 500 DOW Russell 2000
1st Qtr +2.90% +2.50% +1.81% -0.72% +1.12%

    Not surprisingly, the stock market performance in the first quarter was flat with many cross currents tempering the enthusiasm and euphoria of the 30% market gains of 2013. These include:

     Fed tapering of bond buying and the possibility of higher interest rates in 2015
     Polar Vortex: terrible weather in 2/3 of U.S., resulting in poor first quarter sales/earnings
     Russia invading and annexing Crimea from Ukraine and attendant Cold War fears

    The S&P 500 was up +1.8% (with dividends) from 1848 at year’s end to 1872 at the end of March. Five Mile River portfolios outperformed the index in the first quarter as investors took profits in some of the overvalued sectors (internet, social media, biotechnology), and defensive large cap companies came back into favor. 

 In our year end letter we said that the broad stock market was no longer undervalued after the huge rise in 2013. We concluded that a 17 P/E (price to trailing 12 month earnings multiple) was fair valuation, and that the market performance for this year could be up 8% to 9% in a low drama year. Our views have not changed after the first three months, as we believe that dividend growth (not just high absolute yields) will be a critical defense against rising interest rates and a more volatile short-term market in 2014. 

   For much of March and the first week of April, the fast money chasing growth at any price in the overvalued names (Netflix, Tesla Motors, Twitter, Amazon, Gilead, American Eagle) reversed course and took profits in a sharp selloff. However, as we observed at year end, this market is not the internet/dot-com bubble of 14 years ago. Today’s most expensive sectors with price earnings multiples (P/E’s) over 30 represent just 4% of the S&P 500’s market value, versus what was 70% of the S&P 500 companies’ market value in 2000. In the millennium bubble, the ten biggest stocks in the S&P had a P/E ratio averaging 62 times earnings compared to today at a 16 P/E. Among the largest ten companies by today’s market value, only Google’s P/E is above 30. In 2000, Cisco’s P/E was 196! Unlike many of the bubble stocks of the 2000 market, Google has real earnings that are growing more rapidly than the market, a large defensible business model, and is generating significant free cash flow. While we do not own Google, it is a real growth company and it starkly illustrates the difference between now and the past highflying dot-com era. 

 To understand our mindset and our dividend growth emphasis at Five Mile River, the contrast of Google with Microsoft, a new first quarter portfolio addition, is a terrific example. We purchased MSFT at a 14 P/E compared to GOOG at a 30 P/E. GOOG is still in a high growth, no dividend mode, with lots of cash ($58 billion) and strong free cash flow. MSFT is a “mature” high tech dominant company (Windows, Office, Enterprise, XBOX) that has a 3% yield, with a new CEO (Satya Nadella), has lots of cash ($84 billion), impressive free cash flow, and a renewed strategy focus. In the last few months, MSFT broke out of a 13 year “lost in space” period with stronger than expected commercial enterprise sales performance, and management’s commitment to new growth initiatives. Our decision to buy was predicated on significant management change that said “it will not be business as usual.” MSFT has a higher return on investment than virtually all of its peers, and appears to have the motivation to attack newer growth businesses while rewarding shareholders through buybacks and dividends. The management change along with renewed focus on the commercial cloud and consumer mobile offers a way forward for shareholders to realize as much as a 30% total return over the next two years. 

 The flat market in the first quarter makes us focus on why 2014 will be different from 2013. Very simply, 60% of the market appreciation in 2013 was due to the expansion of the price earnings multiple (P/E), while earnings and dividends supplied the balance. 2014 is very likely going to be the opposite. Those companies that can demonstrate strong earnings and dividend growth will likely be the performance gainers this year, while P/E expansion will probably be a minimal contributor to performance. We believe our selections of stable consistent growers will outpace the ‘race horses’ of 2013 when we look back on 2014. This has been the hallmark of our investing style. Our defensive posture and focus on dividend safety has served our clients well, with less volatility and more predictable positive returns since the bottom of the market in 2009. 

 This economic cycle has been historically slow and unpredictable; with record high levels of long-term unemployment; the lowest labor participation rate in decades; and low capital investment. This 2% low growth economy may well last for seven to eight years as we are probably only half way through this expansion. We still have not had a 10% correction in this up cycle, and this bull market is surely due for a pause. We have no idea whether this early April correction in the momentum stocks will broaden into a 10% correction. However, we are not afraid of such a correction, as it would be healthy for a market that has risen for the past five years. Only those who are forced to sell now will be fundamentally disadvantaged. We do not see a recession; we do not see the Fed Chairman Yellen’s bond buying tapering as ruinous tightening; and we cannot identify imminent bubbles forming. Bottom line, we do not see any compelling reason to sell in the hope of buying our dividend growth stocks back cheaper in a few months. The humility of this business is that ‘market timing,’ or the decision to sell now with the hope of buying back at a lower price, is a two decision process almost impossible to execute correctly. In addition there are tax and commission expenses that discourage this behavior. Instead we have chosen to de-risk portfolios through broad diversification of investments (most accounts hold 30+ names), and we have focused on purchasing companies that generate strong free cash flow with attractive yields. These companies generate a growing accumulation of cash, which is a proxy for both dividend increases and share buybacks. These are the best defenses for market volatility, and also the type of investment we think the market will reward in 2014. 

  To close, we incorporate a risk perspective in choosing our investments, which leads us toward more defensive companies, where we have the support of strong balance sheets and free cash flow to survive if a recession were to start tomorrow. One of those defensive sectors is the utility industry, which always underperforms in a growth/small company momentum driven market like 2013, but outperforms in bear markets or sideways markets. One such company, and our only electric utility holding in the very highly regulated utility industry, is Dominion Resources (D): 

     Dominion Resources is the holding company for Virginia Power and North Carolina Power which serves 2.5 million customers in Virginia and northeastern North Carolina along with 1.3 million customers in Ohio and West Virginia. D is up about 7% in the first quarter with a dividend yielding 3.5%, growing 6% to 7% a year. D has produced a total return in the first quarter of about 8%, and our expectation for this well run utility can generate 8% to 10% annual total return over the next several years. We expect additional upside in the second half. Why? Regulation in D’s operating region is favorable relative to most states, and D is forming a Master Limited Partnership (MLP) of its midstream gas assets and its Cove Point liquefied natural gas facilities (export natural gas), and will have an initial public offering in mid-2014. Moderate traditional electric demand growth, supplemented by higher growth coming from it soon to be formed MLP, should provide attractive long-term upside as domestic and international demand for natural gas is expected to grow.

    Thank you for your confidence and support in choosing Five Mile River to manage your financial assets. We welcome any questions or comments in any form at any time.


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.