CLARK & STUART, INC.

Investment Counsel

Dear Friends,

Our year end letter to clients was mailed in early January. Although this edition of our quarterly report has been written later than normal, and stock prices have declined sharply since the start of the year, there is no change in the views we expressed one month ago about the economy and the equity market. Needless to say, there is also no change in our investment strategy.

For the last 14 years our clients have placed their trust in an investment approach which is grounded in the belief that stock prices will, over the long term, reflect the fundamental business performance of the underlying companies. We have executed this strategy by emphasizing investments in companies which are engaged in lower risk businesses and, consequently, achieve consistent and above average growth of profits and dividends. This approach has served us well during periods of greater economic uncertainty. We are confident that it will serve us well again in the current environment.

The Economy

We first identified the “speculative frenzy surrounding residential real estate” almost two years ago and noted that “the housing sector is moving from being a tailwind for the economy to being a headwind.” (Investment Comment 3/31/06) In the same report we stated: “As the era of ‘easy money’ comes to an end, and aggressive speculation continues, major financial accidents are still possible.” The only surprise to us has been the naiveté of so many professional investors, economists, policy makers and financial journalists who clung to the belief that the problems of the housing sector would be “contained.”

All such notions of containment have now evaporated. Over the last few months financial institutions around the world have reported losses of almost $150 billion on investments tied to residential mortgages. Some have estimated that these write-offs will eventually reach $300 to $400 billion. This erosion of capital among banks and other investment firms, the lack of clarity about their total exposure to mortgage-backed securities, and the potential for additional losses as the collateral behind these securities (i.e. the housing stock) continues to decline in value, have produced a credit crunch which threatens to drive the U.S. economy into recession.

Many investors believe that cyclical downturns in the housing industry always lead the broader economy into recession. This view is incorrect. Recessions are typically caused by tighter monetary policies implemented by the Federal Reserve in order to slow the economy and relieve inflationary pressures. Construction of new homes and sales of existing homes are both highly sensitive to the cost of borrowing. Therefore, declines in housing accompany but do not cause economic downturns.

The critical hallmark of recessions is the unwinding of excesses within the corporate sector which produces a vicious cycle of declining profits, capital investment, employment, incomes, demand for goods and services, sales, profits, etc. The good news is that corporate profit margins today remain near record levels because business leaders have been cautious about expanding payrolls and capital expenditures over the last several years. Although business confidence may be fragile, the excesses which typically lead to deep and long lasting recessions are not apparent.

However, recessions can also be caused by policy mistakes. As discussed in our year end letter, the three critical factors now driving the economy (i.e. the housing bust, the credit crunch, and high energy prices) are all deflationary. Therefore, the Federal Reserve may have committed a significant error by placing too much emphasis on the risk of inflation at a time when problems in the banking system have reduced the availability of credit even to consumers and businesses with strong credit ratings.

We believe Fed Chairman Ben Bernanke is keenly aware of the downside risks to the economy. However, other members of the Federal Open Market Committee have exaggerated views of inflation risks; making it difficult for Mr. Bernanke to implement the aggressive easing of monetary conditions required by current economic circumstances. The initial estimate of gross domestic product for the fourth quarter of 2007 showed an increase of only 0.6%. Personal consumption, which accounts for almost 70% of economic activity, increased just 2% – slower than the 2.8% pace of the third quarter. Meanwhile, first time claims for unemployment insurance, a reliable real-time indicator of the job market, have been increasing in recent weeks. This has negative implications for consumer spending going forward.

Fortunately, the Federal Reserve is now moving aggressively to protect the banking system and restore confidence among lenders, borrowers and investors. After lowering the federal funds rate from 5.25% to 4.25% in the final months of 2007, the Fed took the unusual step of cutting rates by 75 basis points a week before its meeting on January 29-30. At that meeting the Fed lowered the federal funds rate by another 50 basis points to 3.0%. We expect additional rate cuts over the next few months.

However, because changes in monetary policy typically impact the economy after a substantial lag, these interest rate cuts may not stimulate the economy until late in 2008 or next year. Also, given the imbalance of supply and demand in the housing industry, it may take longer than normal for lower borrowing costs to stimulate the “credit sensitive” sectors of the economy. Finally, as discussed in our last quarterly report (9/30/07), we expect many Americans to adjust their spending habits over the next few years. The increase in personal wealth during the housing boom allowed many consumers to pursue a lifestyle beyond their means. A protracted period of reducing debt and increasing personal savings lies ahead. The bottom line: even if a recession is avoided, economic growth may remain sluggish much longer than many investors anticipate.

Still, history shows that one should never underestimate the resiliency of the American economy. Indeed, the strong balance sheets of many non-financial companies will allow them to continue hiring and investing. Robust economic growth in developing countries, although they may not be immune to a U.S. recession, will also help to limit the depth and duration of a downturn. Most important, this is an economic system which provides many opportunities and incentives to pursue a higher standard of living. The great strength of the American economy is the simple fact that most Americans go to work each day to make a better life for themselves and their families.

The Equity Market and Our Investment Strategy

The Standard & Poors 500 Index rose just 3.5% last year. Including dividends, the S&P 500 provided a total return of 5.5% -- well below its long term average of 12% annually since the end of World War II. Stock prices were especially volatile in the second half of the year as the deteriorating economic outlook caused investors to become more risk averse.

When the daily gyrations of the stock market become a source of great anxiety, it is difficult to remain focused on one’s long term financial objectives. Many investors become fixated on the scoreboard (the daily results of the market) rather than the game itself (the fundamental performance of the underlying businesses). That is why our clients have hired us – to put aside emotions, to remain focused on the progress of the companies in which we have invested, and to make sure their portfolios are positioned to participate in the eventual upturn of stock prices.

Indeed, one of the cornerstones of our investment strategy is to remain fully invested. It is very difficult to translate broad judgments about the economy into timely decisions about the overall stock market. Even when you are right, the market can make you humble. Many academic studies have highlighted the risks in trying to “time the market.” One recent analysis noted that 85% of the return from stocks between 1985 and 2006 was achieved on only the 40 best days. An investor who was out of the market on those 40 days would have realized an annualized return of less than 2% over those 21 years.

Stock prices could remain volatile for several months. Economic concerns will be compounded by uncertainty surrounding the Presidential election and the possibility of greater regulation in certain industries (e.g. healthcare) and potentially higher tax rates on dividends and capital gains. Given this backdrop, we will remain focused on the two variables which matter most: profits and valuation. As we have stated many times, as long as our companies’ profits and dividends are growing, then their intrinsic value is increasing and so too will their share prices over time. The bottom line: A recession is not an automatic reason to sell stocks. However, fear of recession does cause investors to be less discriminating. Consequently, the best investment opportunities occur at moments like this.

General Electric Company (35.36) On December 11 we attended the annual presentation of Jeffrey Immelt, GE’s Chairman and CEO, to the financial community in New York. Since assuming leadership of the company in 2001, Mr. Immelt has made several changes to GE’s vast portfolio of businesses; generating $55 billion by divesting slower growing, less profitable and more cyclical businesses (e.g. plastics, insurance) and making $88 billion of acquisitions in faster growing and more profitable businesses (e.g. life sciences, water treatment). Although GE’s profits have doubled over the last six years, the real test of Mr. Immelt’s strategy to build “a safe and reliable company,” capable of double digit profit growth even in a tough economic environment, lies immediately ahead.

At the December meeting Mr. Immelt virtually guaranteed that GE would achieve earnings per share growth in 2008 of at least 10% “even if the economy gets worse.” The primary reason for this confidence is the enormous backlog in businesses such as gas turbines, jet engines, and locomotives as well as the highly visible stream of revenues from aftermarket services in these businesses. In 2007 these “infrastructure” businesses accounted for 37% of total company profits. At year end these operations had an order backlog of $44 billion for equipment and about $100 billion for services. This compares to total revenue for GE’s Infrastructure segment of $58 billion last year.

GE’s wide range of financial services businesses, which represented 40% of total company profits in 2007, have been the key driver of GE’s profit growth for many years. Profits in these businesses are split roughly 60% from commercial lending and leasing and 40% from consumer related financial services. The latter includes private label credit cards for retailers – an operation which is clearly vulnerable to the economic slowdown. However, two-thirds of GE’s profits in the consumer finance business are realized outside the U.S. -- benefiting from strong growth in developing countries. Also, GE’s commercial finance operations are well positioned to exploit the problems of major banks whose ability to lend is constrained by their losses in mortgage-backed securities. Well capitalized commercial finance companies like GE can now make loans at higher than normal interest rates and generate strong profit growth for the next several years. Nevertheless, Mr. Immelt offered a cautious forecast; anticipating only 5% growth for profits in financial services this year.

The valuation of GE’s common stock has declined over the last few years as financial services became a larger contributor to the company’s total profits. Investors typically place a lower valuation on the shares of financial companies because of the potential for large negative surprises. This is understandable given the losses reported by many financial institutions over the last few months. However, given GE’s consistent double digit profit and dividend growth, and the fact that its financial services businesses are very different from commercial and investment banks, we believe the valuation decline is unjustified. At recent prices the stock has a price earnings ratio less than 15x -- in line with the overall market -- and, most surprisingly, a dividend yield (3.5%) which essentially matches the yield on ten year U.S. Treasury bonds.

The key point is that GE’s industrial businesses are now expected to grow faster than financial services. This trend could persist for several years. If so, then investors will look back on the current valuation as one of the best opportunities ever to purchase one of the best managed, most reliable and consistent sustainable-growth companies in the world.

Hershey Company (36.17) We visited the company last November. It was a tumultuous year. In 2007 Hershey reported a rare decline in earnings. Sluggish results since mid-2006 lead to the resignation of CEO Rick Lenny and, in mid-November, the resignation of the Board of Directors.

Almost 100 years ago Milton & Catherine Hershey established the Hershey Trust and its sole beneficiary -- the Milton Hershey School, a non-profit school which provides full-time care and education for disadvantaged children. The Trust holds 7% of Hershey’s common stock and over 99% of the company’s Class B shares. These Class B shares are entitled to ten votes per share. Therefore, the Trust holds one-third of the total shares but controls almost 80% of all shareholder votes. We have always held a positive view of the voting control of the Trust. All shareholders benefit from the presence of an owner who has the incentive and the power to create change at the company if and when necessary. The Trust exercised its control in November when it requested the resignations of most of the company’s Directors. All members of the Board resigned except David West, the newly promoted CEO who had joined the company shortly after his mentor, Mr. Lenny, in 2001.

For most of Mr. Lenny’s tenure the company pursued a successful strategy to increase sales in distribution channels, such as convenience stores, where its share of market was less than its overall share of the confectionary market. Sales in convenience stores are dominated by single serve candy bars which generate higher profit margins than the packaged candy and multi-bar packs common in supermarkets and mass merchants. At the same time, Hershey introduced several new products, many initially merchandised as “limited editions;” creating new sales and profit opportunities for retailers and leading to preferred locations for Hershey’s products on store shelves.

From 2001 through 2005 the company achieved strong double digit profit growth. The stock price rose from $32 at the end of 2000 to more than $67 in Spring 2005 – including a 44% gain in 2004 alone. It was clear that investors were overestimating the company’s sustainable growth rate. The shares were overvalued and we reduced our holdings. By the middle of 2006 the stock price had fallen to the low $50’s and we began to rebuild positions in clients’ portfolios. Those purchases were premature.

Hershey’s profit growth began to slow in the second half of 2006. The company scaled back the “limited editions” strategy in favor of new “platforms” (i.e. products which could be offered in a variety of sizes and packages) and “adjacencies” (e.g. cookies in traditional Hershey flavors like Reese’s peanut butter and York peppermint). Some of these “platforms” and “adjacencies” were not successful. At the same time, the company began to incur significantly higher dairy costs due to price increases throughout the food chain because of higher production of corn-based ethanol. Most important, as David West has acknowledged, the company lost its focus on consumers and was slow to capitalize on a key trend – a growing preference for higher priced and more indulgent chocolate.

This will be a rebuilding year. New products will include Bliss and Signatures as well as the new Starbucks brand. A big increase in advertising along with continued high input costs will offset much of the savings from Hershey’s “supply chain transformation” – a three year program to cut costs by reducing and relocating production lines. Mr. West has indicated that earnings per share could decline again in 2008. Still, we believe the company’s challenges are temporary. Hershey has a powerful combination of leading market share and ubiquitous distribution. Also, the confectionary business remains highly profitable because all market participants compete on the basis of innovation and merchandising – not price. Finally, the new Board of Directors is chaired by Ken Wolfe; a no-nonsense executive with a sharp focus on the bottom line who retired as Hershey’s CEO in 2001.

We also believe Hershey will remain an attractive acquisition or merger candidate. The company has a modest presence outside the U.S. and companies such as Cadbury, Wrigley or PepsiCo would provide immediate global distribution for Hershey’s iconic brands. Given its fiduciary responsibility, the Hershey Trust may be agreeable to such a combination when the company’s core U.S. business is back on track and the share price is substantially higher. In other words, the Trust will not sell-out at the bottom and neither will we.

Charles Clark (207-775-1140) S&P 500: 12/31/07 1468

Michael Stuart (860-478-9012) S&P 500: 1/31/08 1379