CLARK & STUART, INC.

Investment Counsel

Dear Friends,

Hubris – Wanton insolence or arrogance resulting from excessive pride or from passion.

Chutzpah – Killing your parents and throwing yourself at the mercy of the court because your are an orphan.

“Hubris” is the word some journalists are using to describe the management of financial institutions over the last several years. Yet, “chutzpah,” especially as defined by our friend Steve, may be a better characterization of the business model at some investment firms which layered more than thirty dollars of debt onto every dollar of capital provided by investors or shareholders.

Securities firms like Bear Stearns Co., which is being acquired by J.P. Morgan Chase & Co. with support from the U.S. Treasury and the Federal Reserve, have always operated with great financial leverage. Normally this leverage is accompanied by a set of disciplines and controls referred to as “risk-management.” Unfortunately, when money is easy, and everyone else seems to be making more of it, risk-management takes a back seat to hubris. Inevitably the Federal government arrives to clean up the mess; often by imposing more regulation, some good and some bad, and all at a greater cost to tax payers.

The Economy, The Equity Market and Our Investment Strategy

The U.S. economy grew just 0.6% in the fourth quarter of last year. The first and second quarters of 2008 will register similar results – or worse. Many believe the U.S. economy is already contracting. Given this backdrop, the Standard & Poor’s 500 index fell almost 10% in the first quarter. The Dow Jones Industrial Average lost more than 7%, and the Nasdaq Composite declined more than 14%. Losses in our clients’ portfolios were modest in comparison.

The economic consequences of reckless lending and investing are still in the early stages. The sub-prime mortgage debacle is only the leading edge of the bad loans and investments on the books of banks, securities firms and investment funds. The bad paper includes securities backed by a variety of loans to consumers and businesses; including the “leveraged loans” which financed many corporate takeovers in recent years. Writing-down these loans and securities has precipitated a hoarding of capital by banks and securities firms as well as a frantic effort to raise new capital. The result is a broad-based “deleveraging” of the financial system.

Credit is the fuel which drives the American economic engine. When credit is plentiful and cheap the economy grows at an above average rate. When deleveraging takes hold, credit becomes scarce and the economy grows at a below trend pace. Given the amount of financial leverage accumulated by both financial institutions and households over the last several years, the deleveraging process will not be completed in only a few quarters. Faster economic growth is possible in the second half of the year due to tax rebates and aggressive interest rate cuts by the Federal Reserve. However, the deleveraging process may keep economic growth at a below average pace well into next year and 2010 as well.

If the economy struggles for as long as we fear, and longer than most investors anticipate, then our strategy of buying high quality sustainable growth companies at reasonable prices will continue to produce superior results. Conversely, if the economy surprises on the upside (highly unlikely), then our investment results will probably trail the market averages. One thing is certain: our investment approach will not include hubris or chutzpah.

Microsoft Corporation (28.38)

Microsoft has been a strong contributor to our investment results over the last two years; appreciating 14% in 2006 and 19% in 2007. However, we have decided to sell the shares because we disagree with the company’s recent offer to acquire Yahoo Inc. In our view, this transaction represents a gross misallocation of investors’ capital and a risky strategy to improve the company’s competitive position in a business, on-line services, which is not a core operation for Microsoft.

In the second half of the 1990’s Microsoft achieved average annual profit growth of 40%. After the Internet/technology bubble burst, the growth rate slowed to less than 5% between 2000 and 2003. Still, Microsoft was one of the few large technology companies able to generate steady revenue and profit growth during this period. We purchased the shares based on the expectation of another significant upgrade cycle for the personal computer industry as well as Microsoft’s success in large computer systems software. After the company’s growth rate accelerated modestly in 2004 and 2005, management decided to invest more aggressively in on-line services (i.e. advertising and search) in order to improve the company’s competitive position vis-à-vis Google and Yahoo. Consequently, Microsoft’s profits increased only 3% in 2006.

Due to the success of new products in both operating systems (Windows Vista) and applications software (Office 2007), earnings per share rose 18% in fiscal 2007 (June). This faster growth rate has continued into the current fiscal year. Revenues rose 29% and earnings per share increased 55% in the first six months. The year-to-year improvement is somewhat distorted by the timing of revenue and profit recognition in fiscal 2007. Still, Microsoft is expected to grow revenues and profits by 18% and 30%, respectively, in 2008.

Given these strong financial results, and an economic environment in which fewer companies continue to post double digit profit growth, Microsoft was regaining its position as a stock market leader. Therefore, it was very discouraging when Microsoft announced its offer to acquire Yahoo on February 1; offering the shareholders of Yahoo a 60% premium for their shares rather than rewarding the shareholders of Microsoft with a more meaningful dividend. The company has offered a combination of cash and shares with a total value of $31 per Yahoo share based on the stock price of Microsoft at the end of January. The offer implied a total value for Yahoo of $44.6 billion.

History clearly shows that very large acquisitions rarely add value for the shareholders of the acquiring company. Two recent and notable exceptions are the acquisition of Gillette by Procter & Gamble and the acquisition of Compaq by Hewlett Packard. The key to success in both of those mergers was the fact that the acquiring companies, P&G and HP, were adding to businesses in which they already possessed strong and sustainable competitive advantages. In contrast, Microsoft has not been successful in on-line services. This business represents only about 5% of total company revenue and has consistently lost money. Indeed, Microsoft is a distant third to Google and Yahoo in the market for on-line searches and associated advertising revenues.

Yahoo is also a troubled company. With approximately $7 billion in annual revenue (over 2/3 from advertising) Yahoo is more than twice the size of Microsoft in on-line services. However, Yahoo’s revenue increased only 8% last year and its profits have declined in each of the last two years. In comparison, industry leader Google, which would still be twice as big in this business as a combined Microsoft/Yahoo, reported revenue growth of 56% and profit growth of 43% in 2007. Still, the advertising industry is inherently cyclical and recent indicators from Google suggest that the market for on-line advertising may not be as immune to an economic slowdown as many investors have assumed.

We fail to see how the combination of these two companies will create a stronger competitor to Google. In fact, it is possible that Microsoft’s strategy is not to enhance its own profitability in on-line services, but rather to damage the profitability of Google and, hopefully, limit Google’s ability to offer on-line alternatives to Microsoft’s lucrative franchise in applications software (i.e. Word, Excel etc.).

Microsoft is offering a very high price for Yahoo. The $44.6 billion offer equates to more than 55x Yahoo’s estimated profits in 2008. By comparison, the current share price of Microsoft ($28.38) equates to a price/earnings ratio of only 15x. Consequently, the transaction will dilute the per share earnings of Microsoft significantly. Steve Ballmer, Microsoft’s CEO, claims that the combination will allow for cost reductions of at least $1 billion; thereby limiting the earnings dilution. Because these “cost synergies” equal almost 15% of Yahoo’s annual revenue, we believe Mr. Ballmer’s assumption is aggressive. Also, very different “corporate cultures” will complicate the integration of the two companies.

Still, Yahoo management claims that Microsoft’s offer is inadequate. Consequently, the deal is currently in limbo and no alternative to the Microsoft offer has emerged. We believe it is only a matter of time before Microsoft prevails – perhaps at a higher price.

One of the most important criteria for judging the skill of a business executive is his/her ability to allocate capital in a manner which enhances a company’s growth and profitability and, ultimately, the returns for shareholders. Microsoft’s share price is 13% lower than before the offer was announced. The stock may recover somewhat as Mr. Ballmer works to persuade Wall Street on the merits of this deal. However, the stock market has removed $40 billion from the market value of Microsoft since the offer for Yahoo was announced: clearly a vote of ‘thumbs-down” on Mr. Ballmer’s ability to allocate capital judiciously. We agree.

We are confident in our ability to re-allocate our clients’ capital to investments where management is focused on the core businesses which drive financial results, better understands its competitive position, and is more committed to rewarding its own shareholders.

Merck & Co. (37.95)

On December 11, 2007, we attended Merck’s annual business briefing at the company’s headquarters in New Jersey. Richard Clark, Chairman, President and CEO, along with Dr. Peter Kim, President of Merck Research, and other senior executives reviewed the company’s strategies for sustaining the turnaround which made Merck one of the best performing holdings among our clients’ portfolios over the last two years. Merck’s shares provided a total return (price appreciation plus dividends) of almost 42% in 2006 and 37% in 2007.

Of course, these exceptional returns are partly due to the fact that Merck’s stock price was severely depressed for many months following the company’s decision to withdraw the pain killer Vioxx from the market on September 30, 2004. Indeed, an investor who purchased Merck at $25.50 in August 2005, after a Texas jury ruled against the company in the first Vioxx trial, would have achieved a cumulative total return of 140% by the end of 2007. Even an investor who purchased the stock at $33 on September 30, 2004, and held it through 2007, would have achieved a return of 91% -- well above the 40% cumulative return for the S&P 500 during that period.

After winning a majority of the Vioxx trials over the last two years, Merck reached an agreement late last year to settle all Vioxx related claims for less than $5 billion – far less than the estimates of $20-$30 billion which some Wall Street analysts had tossed around a few years ago. Most important, the performance of Merck’s stock over the last two years highlights the opportunity created when a company with strong and sustainable competitive advantages is shunned by investors whose judgment is based on limited information and/or a superficial assessment of the company’s challenges. We believe such an opportunity has come again.

In January, Merck and Schering Plough released the preliminary findings of a clinical trial known as ENHANCE. This trial studied the change in the thickness of the carotid (neck) artery walls over two years as measured by ultrasound. The trial included only 720 patients – all of whom have a rare genetic condition that causes very high levels of bad cholesterol and greatly increases the risk of coronary artery disease. Moreover, most of these patients were already receiving treatment for high cholesterol; perhaps limiting the opportunity to achieve further benefit in this study.

In the ENHANCE trial 357 patients received Vytorin, a tablet which combines Zocor and Zetia, and 363 patients received simvastatin; which is simply the generic name of Zocor. However, because Merck’s patent for Zocor expired a couple of years ago, media reports have referred to the ‘Zocor only’ population as having received a “cheaper generic drug.” Essentially, the trial was aimed at determining whether Zetia provided any additional benefit in preventing the buildup of plaque on the neck arteries – a condition long associated with heart attack and stroke. Vytorin and Zetia are marketed by a joint venture of Merck & Schering Plough.

The preliminary results of ENHANCE, released on January 14, showed no significant difference between the two treatments. The results of the study were delayed for over a year because of challenges which scientists faced in trying to evaluate thousands of ultrasound images. Still, critics have charged that Merck and Schering Plough withheld information from the trial in order to protect sales of Vytorin and Zetia. Needless to say, some state Attorneys General are investigating and Congress has issued subpoenas. However, the ENHANCE trial was blinded; that is, neither the patients nor the researchers nor the companies knew which patients were receiving which treatment. Personnel at the two companies were informed of the results on December 31, 2007 and during the first two weeks of January.

Merck’s stock price fell 20% in January. The complete results of ENHANCE were released on March 30 at a scientific conference in Chicago and both Merck and Schering Plough declined further even though the latest data did not include significant new information. Merck’s shares are now down 35% since the start of the year. The price of Schering Plough, which relies even more on the joint venture, has been cut in half. The best explanation for the latest stock price decline seems to be that a panel of cardiologists has recommended that doctors stop prescribing Vytorin and Zetia and rely on statin drugs (i.e. Zocor/simvastatin, Lipitor, Crestor, etc.) which have been shown to reduce the risk of heart attack and stroke in a number of “outcomes studies.”

A few key points have been lost in the noise surrounding ENHANCE. First, this was not a trial designed to study actual outcomes (i.e. heart attacks and strokes). Such a clinical study, involving 18,000 patients, is currently underway and the results will not be known until 2012. Second, Vytorin was not less effective in preventing the build-up of plaque on the neck arteries. The only unambiguous conclusion from this trial is that Zetia did not provide an additional benefit. Third, several previous and much larger studies have demonstrated that Zetia and Vytorin reduce bad cholesterol significantly more than statins alone. The ENHANCE trial provided further evidence of Vytorin’s superior effectiveness at lowering cholesterol. Finally, there was no data to question the safety of Vytorin.

We estimate that the Merck/Schering Plough joint venture contributes 15-20% of Merck’s total profits. Given the adverse publicity surrounding the ENHANCE trial, and the critical comments of a small but vocal group of cardiologists, sales of Vytorin and Zetia may decline. However, most doctors are unlikely to recommend a switch to simvastatin (generic Zocor) or another statin for patients who are achieving their cholesterol reductions goals with Vytorin or Zetia. Moreover, many patients are taking Vytorin or Zetia because they experienced adverse side effects (e.g. facial flushing, muscle weakness) on statins. Although the statin drugs are similar, patients react differently.

Investors are overreacting to the news surrounding ENHANCE. Today’s price/earnings ratio of 11x is almost as low as the 10x P/E when Merck’s stock hit a post-Vioxx bottom in August 2005. Also, investors are once again ignoring the company’s strong growth of new drugs and vaccines, such as Januvia (a treatment for Type 2 diabetes), Gardasil (the first and only vaccine to prevent cervical cancer), and Isentress (a novel treatment for HIV). Merck’s late stage pipeline also includes new medicines and vaccines to treat obesity, migraine, heart failure, osteoporosis, and hepatitis B.

Mr. Clark’s relentless drive to control and reduce costs, and Dr. Kim’s focus on accelerating new drug development, allowed Merck to overcome the one-two punch of the Vioxx withdrawal and the Zocor patent expiration. There will be more challenges, disappointments and risks over the next few years. Still, ‘we have seen this movie before.’

Charles Clark,CFP (207-775-1140)

Michael Stuart,CFA (860-478-9012)

March 31,2008 S&P 500: 1323