| Quarterly Newsletter - 3rd Quarter, 2013 | ||||||||||||||||||||||||||||||
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Five Mile River taxable portfolios continue to outperform the S&P 500 year to date through the third quarter of 2014, with a performance of +13.34% vs. the market return of +8.33%. The FMR third quarter results were flat with taxable accounts performing on average at -0.24%, and non-taxable retirement accounts ending the third quarter at -1.84%. The S&P 500 closed at 1906 on October 10th. In less than a month the market has already declined 5.2% from the September 18th high of 2011. Noting the increased recent market volatility, it would not be a surprise to see the first meaningful market correction in over three years. The S&P 500 has already registered more than half of a typical 5% to 10% correction.
Cash – Bonds - Stocks: What Do We Want to Own Now, and Why?
In considering our commentary for this fall letter, we thought it helpful to explain our thinking regarding FMR investments, and why stocks are still preferred over cash and bonds. The stocks in Five Mile River portfolios are consistent with our strategic approach to value investing. As you well know from past Five Mile River quarterly letters, we have zeroed in on finding and owning sustainable competitive business models with management committed to both paying/growing dividends, as well as, timely share repurchases. These company’s profits are defensible in slow growth economies and can withstand competitive threats. Companies held in Five Mile portfolios uniformly have sizeable and growing free cash flow, which equates to growing dividends year after year. These characteristics are formidable, especially in the current environment, when the stock market’s price earnings multiple (P/E) is signaling “fair valuation” for most stocks.
Sitting on the sidelines in CASH for the last 5+ years has earned investors nothing and in fact has produced negative real returns after inflation as the Federal Reserve has kept short-term interest rates near zero. BONDS have provided very good returns as long-term interest rates declined from their 2008 Great Recession peak. However, the Federal Reserve’s massive bond buying program, called quantitative easing or QE, will be ending before year end. We believe that the current 10-year Treasury Note yield of 2.3% will mark the cyclical bottom for long-term interest rates in 2014. A 2.3% return for the price risk assumed is not an adequate return to warrant buying long-term bonds with QE ending. The bond market has very likely peaked at current yields. These low long-term Treasury rates have recently been supported by the flight to safety of international capital because of crises and slowing global growth outside of the U.S.
On the other hand, U.S. STOCKS outperformed both cash and bonds since the bottom in 2009. The S&P 500 index closed this quarter up almost 200% from the March 9, 2009 low (the intraday low on March 9, 2009 was 666 and the close of the S&P index on September 30, 2014 was 1972). As was made clear in the FMR 2Q14 letter, even with unprecedented easy money policies by central banks, economic growth remains slow or slowing in most of the world’s developed economies. Structural disincentives and dysfunctional fiscal policies proliferate from Argentina to Japan to Italy. The P/E has been a very big tailwind in stocks’ outperformance over the last two years. Without a sudden turn in adopting prudent fiscal policies, the expansion of the P/E ratios is now largely over for the majority of stocks. While corporate profits and dividends should continue to grow for the average S&P 500 company, profit margins are at record highs and earnings growth is likely to slow. This is not an “end of the world” scenario, but expected average annualized equity returns from this current level are likely to be in the +6% to +7% range, below the long-term average of +9% to +10%. We believe that from current valuation levels, FMR’s dividend growth focus should generate superior returns of +8% to +9% for common stocks with 40% to 50% of that return coming from dividends.
A strategy of selling all or a large percentage of your stocks and holding cash or trying to time the market are not viable options and are mistakes unless one is clairvoyant. While it may sound easy and practical as a reaction to perceived real or unreal risks, it is nearly impossible for 99% of investors to implement because you have to make two right decisions. Psychologists have a phrase for the dilemma of holding two conflicting thoughts or beliefs at the same time: cognitive dissonance. Typically investors are really uncomfortable at either making the first decision to sell or the second decision to buy back, and they over-estimate their own fortitude or ability to execute both decisions correctly in real time with their own money. Predicting both a bubble and a deep oncoming recession is a tough and nearly impossible game to play. None of these “black sheep” events or “shocks” are visible to us for the rest of this year or through 2015. Corrections of 5% to 10% should be expected not with horror but as opportunities to buy more attractively valued, free cash flow dividend growers, rather than go to cash. Former Federal Reserve Chairman Ben Bernanke did not recognize the sub-prime mortgage bubble, and it is unlikely that new Chairman Janet Yellen will identify the next bubble. The U.S. financial system is not perfect, but both large and small banks are much safer with stronger balance sheets, and compared with 2008, can now more easily handle liquidity stress.
We expect gradually rising short-term and long-term interest rates (to 1.5% and 3.5% respectively) over the next several years along with moderate U.S. economic growth (2% to 3%). We do NOT expect further expansion of P/E multiples without major changes in our fiscal policy. We do know that bad “world event news” (Ebola, Ukraine, terrorism) will always be in the daily headlines, and while alarming to be sure, we recommend that long-term investors not overreact and abandon long-term investment objectives. We continue to invest in opportunities that fit our growing dividend focused investment strategy. You should expect to see major value creating corporate restructuring events such as the major combination of the general partner with the limited partners at Kinder Morgan Inc (KMI, KMR, KMP). Large positions in KMI, KMR, KMP and WPZ (Williams Partners) have provided significant positive performance and will continue to provide a growing stream of dividend income. In a fairly valued market where bargains are hard to find, restructuring and growth/dividend stocks typically offer lower absolute downside protection, and make for a safer long-term investment strategy in difficult market environments.
Company Comments: Lockheed Martin (LMT) and Raytheon (RTN)
Two of our long-term holdings, Lockheed Martin (LMT) and Raytheon (RTN), major defense sector companies, have provided excellent capital appreciation over the past two years (+75% to +90%). Both companies have generated growing sustainable free cash flow, fueling consistent dividend growth (8% to 15%) and attractive current yields (2.4% to 3.4%). Defense spending is bottoming in fiscal year 2015 (estimated at $495 billion), having declined by 45% from its peak in 2008. Despite withdrawal of troops from Iraq and Afghanistan, strategic defense companies like LMT and RTN are better positioned than others because of both their specific product focus, and their rapidly growing international sales with global unrest.
While U.S. defense capabilities have been drawn down across the board over the last six years, sequestration is now highly unlikely given increasing demands on our military. While the U.S. has been disengaging from the Middle East, we have all read of the recent rapid expansion of ISIS, ISIL (Islamic State Caliphate), Khorasan (Syria), Boko Haram (Africa) and other terrorist groups around the world. These have forced the U.S. to re-engage and lead the worldwide fight against terror. At the same time, the Russian aggression in taking over the Crimean peninsula and parts of Ukraine has put NATO, as well as our Middle East allies on high alert. Also, several Asian/Pacific countries are ramping up their defense budgets to improve their capabilities to counteract China’s dramatically increasing defense budget (+10% to +12% a year on a $130 billion base). In turn, Japan, concerned about China, has abruptly reversed course from a declining defense budget to a rising budget ($50 billion base).
Allies and partner nations around the world are purchasing ground-based air defense systems, intercept missiles (Israel, Saudi Arabia), airborne and ground-based radar systems, enhanced defense communication systems, and F-16, F-22, F-35 and C-130 aircraft. LMT and RTN are the gold standards for the highest performance defense platforms. Both LMT and RTN will likely benefit from the focus on more and more high-tech offerings, surveillance, and data tracking programs to fight cyber threats. We continue to own both of these dominant defense names in FMR portfolios as the boards and managements of both companies are committed to returning value to shareholders through increased annual dividends and substantial share repurchase programs.
We look forward to the opportunity to discuss any and all questions regarding Five Mile River investment strategies.
Sincerely,
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.
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