Quarterly Newsletter - 1st Quarter, 2014
PERIOD FMR* Taxable FMR* Retirement S&P 500 DOW Russell 2000
1st Qtr -1.16% +2.54% +0.95% -0.26% +4.32%

   Our expectation of increased stock market volatility this year has been supplied in abundance with 2015's first quarter results. The market started off the year down four days in a row, followed by a big rally to new highs in February continuing into early March, and then down again at quarter end to finish essentially flat at +0.95% for the quarter. 

 The two most notable events of the first quarter involved oil and the Federal Reserve. First, it is likely that the price per barrel of oil bottomed during the quarter. Second, the Federal Reserve removed the word "patient" on March 18th from its forward guidance on normalizing interest rates. Regarding the second event, this statement signals the end of the Zero Interest Rate Policy (ZIRP) which has been in effect since December 2008 (ZIRP has suppressed the short-term federal funds rate to between 0% and .25% for the last six years, which in turn has affected short-term debt instruments such as home equity loans, margins loans and individual savings accounts). Chairman Yellen made it clear that removing the word "patient" does not mean an early normalizing of interest rates after six years of ZIRP. You would be correct to think that the Federal Reserve has itself in a bit of a box with $4 trillion of government debt on its balance sheet, a historic number, and only modest economic stimulus to show for creating this much money. The chairman leaned heavily on words that indicated there would be no federal funds rate increase before the June meeting, implying it may be Fall 2015 before the first increase. Uncertainty, and the accompanying volatility, is the "certainty" that continues. 

   Corporate profits for the first quarter will be disappointing for many sectors and companies. Contributing to weak first quarter corporate profits were the rapid appreciation of the U.S. dollar against virtually all world currencies, a significant negative impact from the West Coast Port slow down and severely cold weather across much of the U.S. Additionally, there has been no sustainable acceleration to the anemic pace of GDP growth of approximately 1% to 2% since the Great Recession. Our caution from mid-year 2014 continues, as most sectors of the stock market remain fairly valued to overvalued at the end of the quarter. Further price to earnings ratio (PE) expansion would be hard to sustain in the absence of accelerating earnings growth at the current level which is 17x the 2015 estimated earnings for the S&P 500. Therefore, a flat stock market is not a surprise given the market's current valuation. Weather will improve following the worst winter in 25 years, the West Coast Port strike has been settled and the worst of the dollar's strength is probably behind us, so the economic data should strengthen as the year unfolds, and so too should corporate profits. 

 Our central 2015 forecast for the S&P 500 is a mirror image of our forecast for corporate profits, which will likely range between +4% to +11%, with a median gain of +7.5%. This mildly positive full-year forecast is still attainable after the first quarter's flat performance as neither we nor the Federal Reserve expect a spike in inflation or interest rates in this calendar year. Inflation remains below the Federal Reserve's desired level of 2%. Other considerations include underlying job growth, which had been gradually improving but was reported significantly below expectations for March (April 3rd report). The headline unemployment rate of 5.5% significantly overstates the languid condition of the labor market. Labor participation rates for men ages 25 to 54 (a measure, in this case of men in the prime-age work group actively looking for a job) is at a 66 year low or just 87.9%. Another statistic called U-6, calculates labor underutilization by counting part-time workers who want full-time work and those that have given up looking for work. That number is now over 9 million people, which is 1.8 million above levels prior to the Great Recession in November 2007.  

Oil Bottoming - The Law of Supply and Demand 

 In our 2014 mid-December Five Mile client letter that focused on the issues surrounding oil, we discussed the dramatic drop in the price of crude oil from $105 to $60 in less than six months. Our message was two-fold:  


  1. The free market is working fine and doing what it is supposed to do, as lower prices of this magnitude lead to significant cutbacks in drilling and ultimately curtail the growth in oil production (supply) as a result of a cutback by marginal high-cost U.S. oil producers. This free market process for balancing supply to demand will not resolve in days or weeks, but should reach equilibrium in the next three to four quarters when pricing should settle around the marginal cost to produce a barrel of oil between $75 and $80.
  2. A number of Five Mile River's energy investments have corrected as the price of oil has come down, however these companies' businesses are predominantly unaffected by commodity prices. We own "mid-stream" energy assets such as pipelines, storage terminals and processing facilities that earn income based on product volumes, not commodity prices. Simply putting in place a bottom in the price of oil (which we believe has now occurred) will provide a reason for these high recurring revenue companies to see a strong stock price rebound.

 There are indications that support our belief that we reached the bottom of the oil price decline two months ago at $44.00 per barrel. The West Texas Intermediate (WTI), the U.S. oil benchmark price, has been trading anywhere from 9% to 18% higher since January in a range of $47 to $52 a barrel. By the time you receive this letter, the U.S. drilling rig count will be down about 1000 rigs from its peak of 2000, and could well drop under 1000 rigs this spring. Previous bottoms in oil prices have been associated with 50% declines in rig activity. We expect that the $50 billion dollar cut in the oil industry capital expenditures this year, along with rapid reservoir depletion, will lead to flat and probably declining U.S. production by the fourth quarter of 2015. As the drilling budget cuts are implemented, this will cause a rapid decline in production because shale wells experience 40% to 80% depletion in the first year, compared to 5% depletion in the average vertical well. Supply economics dictate a decline in drilling until supply and demand return to equilibrium. When this occurs the price should attain or exceed this marginal cost of $75 to $80. Also of note is the fact that world-wide energy demand continues to grow at its historic rate of +1%, and producing reservoirs continue depleting which require the industry to find 4 million to 5 million new barrels per day in order to simply hold supply and demand constant.

 As the market realizes that a bottom has been put in place for oil, our energy investments should rebound handsomely. The shakeout in the oil industry has been sharp and compressed in time over the last three to four months. The strongest companies with the largest low-cost reserves and the best balance sheets will not only survive, but will come back stronger both in higher productivity and higher stock market valuation from current undervalued prices. We forecast +30% to +50% return potential over the next two to three years from these "best in class" companies.


 Our strategy focus since the end of the Great Recession has been to prioritize companies that can sustain growth in free cash flow because they possess substantial competitive moats. These companies have had many more options during this continuing slow growth recovery such as: stock buy-backs, spin-outs, divestitures, acquisitions, and of course, above average and growing cash dividends. Over long periods, higher-yielding stocks with growth protected moats have tended to outperform low or non-yielding stocks. Higher-yielding stocks also benefit from lower stock price volatility. These businesses can more reliably weather periods of weak economics and still generate consistently growing cash flows, buybacks and dividends. While the beginning of the normalization of interest rates is likely to occur later in 2015 or early 2016, it is important to remember that historically stocks do not peak until more than two years AFTER the first increase in interest rates. The kinds of companies we favor grow their annual dividend payments, which provide an added advantage versus other stocks and certainly compared with bonds. This is especially true during periods of rising interest rates.

 American Tower Corporation

 American Tower (AMT) is the largest independent owner and operator of wireless telecom and broadcast towers. It owns and operates over 100,000 towers in the U.S., Brazil, Chile, Mexico, Columbia, Nigeria, Germany, South Africa, India and a half dozen other smaller countries. AMT operates as a real estate investment trust (REIT). A REIT, by definition must: 1) invest at least 75% of its total assets in real estate; 2) derive a minimum of 75% of its gross income from rents from real property; and 3) must pay at least 90% of its taxable income in the form of shareholder dividends each year by law. American Tower's primary business is leasing antenna space on multi-tenant communication towers to wireless service providers (ATT, Verizon, T-Mobile, Vodafone, Telefónica and América Móvil), radio and television broadcast companies, wireless data providers and government agencies.

 Mobil data traffic carried on towers is one of the fastest growing and most dynamic technology sectors with significant barriers to entry. In the case of the tower business, their moats are the owned and leased tower real estate locations. AMT not only has 60% of its towers in the top 100 U.S. markets, but it has a large and rapidly growing presence in Mexico and Brazil where operating profit margins are 90%. In the case of AMT, moats mean not only the best locations within those markets, but also having the height and structural capacity allowing the addition of multiple mobile service providers. Mobile data traffic is growing at an estimated 50% compounded rate! This growth has been caused by the confluence of an explosion in the number of mobile devices, the increasing data transmission demands from applications such as streaming video and the requirement for faster high quality download capability. AMT has a strong balance sheet, access to capital, high return on invested capital and 8%+ core organic growth. AMT's adjusted funds from operations (AFFO) is the most conservative standard used to measure performance in the REIT industry. AFFO for AMT increased at 15.8% per share in 2014 from a combination of new business customers, rent escalations, more equipment/customers per tower and new tower builds. The tower business is inherently attractive because of the long-lived nature of a tower asset from a low maintenance standpoint. Also, there are barriers to entry into the marketplace because of the "not in my back yard" effect (NIMBY) which creates difficulty in securing new cell tower locations. This kind of real estate has long-term visibility and produces double-digit net income growth, thereby leading to outstanding dividend growth. AMT's dividends should grow at 20% per year over the next three years with today's asset base. AMT's dividend for 2014 was $1.40 per share and will more than double to an estimated $2.85 per share in 2017.

Five Mile River is committed to long term financial health by conservatively growing assets using one of three primary investment strategies for portfolios: growth, income or a balanced strategy, combining both growth and income. We welcome questions that you would like to have.


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.