CLARK & STUART, INC.

Investment Counsel

Dear Friends,

We have written to you, our clients, each month since the financial crisis erupted last Fall; hoping to provide a reassuring perspective on the economic outlook and to sustain your faith in the long term rewards from investing in common stocks. Our top priority is to keep you invested in the equity market in order to participate in the eventual recovery of share prices.

We also want to assure you about the future of our service. From time-to-time some of you have inquired about our personal financial well-being. We appreciate your concern. Because of the decline in our clients’ portfolios over the past few months, our compensation will fall by 25-30% in 2009. However, you should have no doubts about our staying power. Clark & Stuart has no debt and our non-compensation operating expenses are less than 7% of our annual revenue. We are in this for the long haul – just like you.

We are also determined to sustain your faith in our investment approach. For many years this quarterly Investment Comment has included the individual company research which is the hallmark of our service and our strategy. Over the past few months we have focused instead on trying to help you better understand the broader dimensions of the economic and financial crisis. Going forward we will be providing a steady flow of company-specific reports. Amid today’s many uncertainties, our own confidence has been sustained by focusing on the enduring business models and long lasting competitive advantages of these outstanding companies. We are sure that you will share our conviction.

The Economy and The Equity Market

Since our last letter on January 5 the economic news has continued to be grim. At the end of January the Commerce Department reported that Gross Domestic Product (GDP) decreased at an annual rate of 3.8% in the fourth quarter of 2008. This “advance” estimate is based on incomplete data. A larger contraction is expected when more comprehensive data is released at the end of February. Other headline statistics include a continuing decline in payrolls (1.8 million in the last three months) and an increase in the national unemployment rate to 7.6%.

Stock prices declined sharply in January as investors braced for disappointing year end profit reports. The Standard & Poors 500 index fell 8.6%. Data junkies like to point out that stock market declines in January often foreshadow a negative result for the full year. Needless to say, we believe investors should give little attention to such random statistics and focus instead on the fundamental economic backdrop and the investment merits of individual securities. However, just to set the record straight, since the end of World War II (and prior to this year) share prices have fallen 22 times in the month of January. In only 9 of those years has the full year decline been greater than the loss of the first month.

As we write this letter in early February, it is obvious that the center of the American economy has shifted to Washington. Policy-makers are engaged in conversations with important but unpredictable consequences. The House of Representatives has passed fiscal stimulus legislation estimated at more than $800 billion of tax cuts and incremental spending. The Senate will soon vote on a stimulus of similar size. Also, by the time you receive this report the U.S. Treasury will announce new initiatives to increase the capital of the country’s largest financial institutions and alleviate the burden of bad loans and investments still on their balance sheets.

These policy measures are absolutely necessary. However, a brief review of history is helpful in evaluating the potential of Washington to fix a broken economy.

“Whatever needs to be done”

When Americans went to the polls in November 1980 the economy was trying to recover from a sharp recession earlier that year. In a misguided effort to reign-in rampant inflation (13% in 1979), the Carter Administration had imposed severe controls on credit. Personal consumption and business investment collapsed. Gross Domestic Product contracted at an annual rate of 7.8% in the second quarter. Unemployment rose quickly from 6% at the end of 1979 to 7.8% in the middle of 1980.

“These United States are confronted with an economic affliction of great proportions. … Idle industries have cast workers into unemployment, human misery, and personal indignity. … The economic ills we suffer have come upon us over several decades. They will not go away in days, weeks, or months, but they will go away. They will go away because we as Americans have the capacity now, as we’ve had in the past, to do whatever needs to be done to preserve this last and greatest bastion of freedom.”

Ronald W. Reagan

January 20, 1981

President Reagan proposed a stunning 30% tax cut for individuals and business, significantly increased spending for national defense, and sharp reductions in other discretionary spending. Despite a great sense of urgency, widespread popular support for the President, and Republican control of the Senate, the Reagan economic program did not win Congressional approval until July 1981 and the tax cuts were scaled back to 25%. Critics warned of higher interest rates due to sharply higher budget deficits. (Does this sound familiar?)

At the same time, the Federal Reserve, under the leadership of Paul Volcker, tightened monetary conditions dramatically – pushing short term interest rates over 19%. Treasury bond yields exceeded 14%. Mortgage rates were higher still. The economy contracted in four of the eight quarters in 1981 and 1982. Unemployment continued to rise – peaking at 10.8% by the end of 1982. Pessimism and despair were widespread. Mr. Volcker was vilified for creating the worst economic environment since the Great Depression. (Does this too sound familiar?)

Twenty years after the end of his Presidency, economists continue to debate the success or failure of the Reagan economic program. This is not surprising. Economists also continue to debate the causes of the Great Depression and the success or failure of Franklin Roosevelt’s New Deal. There is no debate, however, about the extraordinary leadership of Paul Volcker.

Mr. Volcker understood the true meaning of Reagan’s words: “whatever needs to be done.” Only by deflating the economy was it possible to crush inflation. This was a decision that elected leaders, motivated by political ambition, were unwilling to make. In the summer of 1982, several months before the peak in unemployment and the official end of the recession, stocks and bonds began the longest and strongest bull market in history. Two years after Reagan’s inauguration, a sustainable economic expansion was underway. Today, Paul Volcker is revered as history’s greatest central banker. At age 81 he is also a key advisor to President Obama.

$800 Billion

Today’s economic emergency is very different. Thirty years ago the economy was gripped by double digit inflation. Today’s economy is trapped in a self-reinforcing deflationary spiral of lower spending, production, employment and income. A different policy prescription is needed. Importantly, only the Federal Government has the resources to break the deflationary spiral which was triggered by the end of the credit bubble and the deleveraging of both the consumer and financial sectors of the economy. Unfortunately, the fiscal policy response which has been offered by Congress looks somewhat timid.

In recent days much has been said and written about the $800 billion stimulus measures in the House and Senate. Media reports have focused on the politics behind the stimulus package; i.e. the lack of bi-partisan support, the mix of tax cuts versus increased spending, and which programs have been favored or sacrificed in congressional negotiations. These reports have overlooked the most important question. Is $800 billion enough?

In 2008 total federal government spending was $1.1 trillion. Spending by state and local governments was substantially higher at $1.8 trillion. In this context, $800 billion looks like a significant number. However, $800 billion represents just 5.6% of U.S. Gross Domestic Product. Although many economists expect the “knock-on” benefits of fiscal stimulus to multiply the impact on aggregate demand, the spending portion of this stimulus is expected to be spread over two or more years. Also, consumers are likely to use some of the tax cuts to increase their savings and reduce their debts. Therefore, the impact on aggregate demand from this stimulus will be well below $800 billion in the next 12 months.

As noted above, in the fourth quarter of last year the economy contracted by 3.8%. Many economists expect revised data to show the economy slowing at a rate closer to 5% -- an annual decline in aggregate demand of more than $700 billion. Therefore, an $800 billion stimulus may mitigate the downside risks to the economy, but it will not restore the economy to trend line growth in the short term.

“All available tools”

Fortunately, the Federal Reserve has emerged once again as a far more aggressive policy-making body. The Fed has lowered its target for the Federal Funds rate, the interest rates at which banks lend to each other, to a range of .00%-.25% and dramatically expanded its role as the lender of last resort.

Under the leadership of Ben Bernanke, the Fed has implemented a number of programs which allow the central bank to bypass the dysfunctional banking system and have a more direct impact on the availability and the cost of credit. This has included facilities to purchase commercial paper (i.e. short term debt of corporations), debt securities issued by the government’s mortgage agencies (Fannie Mae and Freddie Mac), mortgage-backed securities, and securities backed by a wide variety of consumer debt (credit cards, auto loans, and student loans).

At the end of its January 28 meeting the Federal Reserve stated its intention to “employ all available tools to promote the resumption of sustainable economic growth.” Mr. Bernanke, who earned his doctorate by studying the Great Depression, fully understands the meaning of “whatever needs to be done.” In order to escape a self-reinforcing deflationary cycle, policy-makers must be willing to re-flate the economy and deal with the risk of higher inflation in future years.

When the banking system is functioning normally again, the economy will likely enjoy a growth spurt driven by pent-up demand and the trillions of dollars pushed into the financial system by the Fed. Also, the same information technologies which allowed manufacturers to shrink their supply chains and shorten their production cycles, have facilitated a sharp decline of inventories in recent months. When demand recovers these manufacturers and distributors will rush to increase production in order to avoid lost sales due to inadequate inventory.

However, the economy will still face the headwind of consumers who need to limit their spending, increase savings and reduce their debts. Twenty eight years ago, at the start of the Reagan Presidency, personal consumption accounted for just 62% of economic activity. Last year consumers accounted for 70% of GDP. America’s dependence on consumer spending has also driven the value of imported goods from only 8% of the economy 30 years ago to almost 15% of GDP today. This growth in imports has not been matched by growth of exports. Instead, America depends on the willingness of foreigners to finance our consumption by purchasing our government debt. This is not sustainable. The next few years may be the start of a long term rebalancing of the global economy.

Investment Strategy

As you know, we continue to practice an investment approach which relies on (1) independent fundamental analysis of businesses and companies, (2) discipline and patience in order to minimize trading costs and taxes, and (3) face-to-face contact with corporate executives in order to judge their personal integrity as well as their business skills. To some this approach may seem quaint in the era of “Mad Money” and “Fast Money.” Indeed, over the last several months, many commentators, fund managers and trigger-happy-traders have declared that long term investing is dead.

In November 2005 we addressed the question: Is our strategy obsolete? At that time our results had been lagging, for a few years, the returns which others were achieving by investing in popular investment themes such as real estate, energy stocks, industrial commodities, and small capitalization stocks. Needless to say, much has changed (in our favor) since late 2005. Here is how we summarized our investment approach at that time.

“Our investment strategy is designed to capitalize on discrepancies between price and value – between the stock market price of a company and the intrinsic value of the company. Stock prices, in the short term, are determined by what others are willing to pay for a share of the company based on a wide variety of variables, many of which are external to the underlying company … Intrinsic value is what we are willing to pay in order to buy the whole company.”

Estimating the intrinsic value of a company is challenging under any circumstances. It is especially difficult if the company is engaged in businesses which are highly cyclical – producing profits, cash flows and dividends which are volatile and uncertain from year to year. That is why we place so much emphasis on stocks which we call growth bonds; companies which provide a reliable and growing stream of income (dividends) as well as sustainable long term growth in the value of principle (the intrinsic value of the company). These are the companies which have the resources to gain market share, through investments or acquisitions, in an economy which will be characterized by survival of the strongest.

Growth Bonds

Listed below are sixteen companies which currently account for 87% of the assets under our supervision. For most of our clients these stocks represent their entire portfolios. As shown by the number of years of consecutive annual dividend increases, most of these companies have provided cash returns to investors which are as reliable as any bond. Indeed, some of these companies have paid dividends for generations: e.g. Walgreen 75 years, 3M 91 years, and P&G 119 years.

In the past year, while many corporations were cutting or eliminating their dividends, these stocks provided an average dividend increase of 12%. Also, the average dividend yield of these stocks is now above the current yield of 10 year U.S. Treasury bonds (about 2.9%) – a highly unusual development. This is true even if we exclude General Electric, whose 11% yield suggests that many investors expect the company to cut its dividend due to declining profits in its financial services business.

Procter & Gamble has had 52 consecutive years of dividend increases, a 14% dividend increase last year, a 11% average increase over the last 10 years, $1.60 is the current dividend, price on 2/6/09 is $54.00 and the current yield is now 2.9%.

Emerson Electric has had 52 consecutive years of dividend increases, a 10% dividend increase last year, a 7% average increase over the last 10 years, $1.32 is the current dividend, the price on 2/6/09 is $33.43 and the current yield is now 3.9%.

3M Company has had 50 consecutive years of dividend increases, a 4% dividend increase last year, a 6% average increase over the last 10 years, $2.00 is the current dividend, the price on 2/6/09 is $52.39 and the current yield is now 3.8%.

Coca-Cola has had 46 consecutive years of dividend increases, a 12% dividend increase last year, a 10% average increase over the past 10 years, $1.52 is the current dividend, the price on 2/6/09 is $43.55 and the current yield is now 3.5%.

Johnson & Johnson has had 45 consecutive years of dividend increases, a 11% dividend increase last year, a 14% average increase over the past 10 years, $1.84 is the current dividend, the price on 2/6/09 is $58.51 and the current yield is now 3.1%.

Sysco Corporation has had 38 consecutive years of dividend increases, a 9% dividend increase last year, a 18% average increase over the past 10 years, .96 is the current dividend, the price on 2/6/09 is $24.67 and the curent yield is now 3.9%.

Pepsico has had 36 consecutive years of dividend increases, a 13% dividend increase last year, a 12% average increase over the past 10 years, $1.70 is the current dividend, the price on 2/6/09 is $53.53 and the current yield is now 3.2%.

Automatic Data has had 34 consecutive years of dividend increases, a 14% dividend increase last year, a 16% average increase over the past 10 years, $1.32 is the current dividend, the price on 2/6/09 is $39.57 and the current yield is now 3.3%

Walgreen has had 33 consecutive years of dividend increases, a 18% dividend increase last year, a 13% average increase over the past 10 years, .45 is the current dividend, the price on 2/6/09 is $28.16 and the current yield is now 1.6%.

Medtronic has had 22 consecutive years of dividend increases, a 50% dividend increase last year, a 19% average increase over the past 10 years, .75 is the current dividend, the price on 2/6/09 is $33.39 and the current yield is now 2.6%.

Stryker has had 17 consecutive years of dividend increases, a 21% dividend increase last year, a 30% average increase over the past 10 years, .40 is the current dividend, the price on 2/6/09 is $42.98 and the current yield is now 0.9%.

Illinois Tool Works has had 16 consecutive years of dividend increases, a 11% dividend increase last year, a 15% average increase over the past 10 years, $1.24 is the current dividend, the price on 2/6/09 is $35.82 and the current yield is now 3.5%.

Intel has had 5 consecutive years of dividend increases, a 10% dividend increase last year, a 34% average increase over the past 10 years, .56 is the current dividend, the price on 2/6/09 is $14.73 and the current yield is now 3.8%.

Hershey prior to 2008 has had 33 consecutive years of dividend increases, 0% dividend increase last year, a 10% average increase over the past 10 years, $1.19 is the current dividend, the price on 2/6/09 is $37.48 and the current yield is now 3.2%.

GE prior to 2008 has had 32 consecutive years of dividend increases, 0% dividend increase last year, a 11% average increase over the past 10 years, $1.24 is the current dividend, the price on 2/6/09 is $11.10 and the current yield is now 11.2%.

Merck has held its dividend level since the withdrawal of Vioxx in 2004. Merck had a 5% average increase over the past 10 years, $1.52 is the current dividend, the price on 2/6/09 is $30.77 and the current yield is now 4.9%.

In total our companies had an average dividend increase of 12% last year and have a current average yield of 3.7%.

A traditional bond pays the same rate of interest year after year and returns to the investor a fixed value on a specific date in the future. Growth bonds have an uncertain future value, but will produce a growing stream of profits and dividends indefinitely. Thus, a company whose stock has a yield of 3.2%, and grows its dividend at an average annual rate of 10%, will see its yield increase to more than 8% in 10 years. That is why stocks which are growth bonds deserve to be valued at multiples of profits and dividends well above the average stock. Today, however, stocks in general are priced as if profit growth is extinct – reflecting the widespread fear of a long lasting recession -- and growth bonds are priced at levels not seen since the early 1980’s.

If these companies, as a group, continue to increase their dividends at a double digit rate, it is highly unlikely that their yield will reach 8%. Instead, their share prices will also increase so that the dividend yield remains closer to the risk free rate of return from Treasury bonds. That is the real power of growth bonds. As we have stated many times, as long as a company’s profits and dividends are growing, then its intrinsic value is also growing -- so too, eventually, will its share price. Given all the uncertainties in today’s financial markets, these companies, these growth bonds, are a source of great confidence and optimism.

Charles Clark (207-775-1140) S&P 500: 12/31/07 903

Michael Stuart (860-478-9012) S&P 500: 1/31/08 869

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