CLARK & STUART, INC.

Investment Counsel

Dear Friends,

Stock prices are down sharply. Investors’ confidence has been badly shaken. Some economists and journalists have made exaggerated comparisons with the Great Depression. In times like this it is helpful to remember our history.

Two hundred thirty-two years ago today a small group of men assembled in Philadelphia to affirm the birth of a nation whose founding principles included equality, liberty and the pursuit of happiness. Preserving and advancing these principles has always been complicated by the obvious conflicts among them. Thus, our laws, our institutions and our economy are highly imperfect. Yet, never has there been a system of government and economy which provided more opportunity to pursue one’s happiness. Simply put, most Americans go to work each day in order to achieve a better standard of living, a secure retirement, and more opportunities for future generations of their families. Therein lays the great resilience of the American economy.

Although it is fashionable to criticize our leaders and our institutions, especially during a Presidential election year, we are well served to remember the great determination of the American people. Never bet against the American people – that strategy has not worked for over 230 years.

We have been through periods like this before. With a sensible investment approach, and confidence in the resilience of the American economy, we will get through this as well. Still, the primary goal of this report is to sustain your confidence. Therefore, we have devoted more of this letter than usual to a discussion of broader economic and stock market issues. If this does not provide the reassurance you need, then please do not hesitate to call us.

In mid-March the collapse of investment bank Bear Stearns prompted unprecedented actions by the Federal Reserve. By now serving as the lender of last resort for investment banks as well as commercial banks, the Federal Reserve has signaled that it will take whatever measures are necessary to prevent the failure of other major financial institutions.

Consequently, many investors concluded that the worst of the credit crisis had passed and that the current economic slowdown (or recession) would be followed by recovery later in 2008. After declining almost 10% in the first quarter, the Standard & Poors 500 Index rose nearly 5% in April and better than 1% in May. This complacency was shattered in June. For the first six months of 2008 the S&P 500 fell 12.8% (excluding dividends).

We believe the most recent decline in stock prices reflects two fears among investors. (1) Whether or not the U.S. is currently in recession, the economy will experience below-average growth for an extended period of time. (2) The sharp increase in the cost of oil and other commodities will force the Federal Reserve to raise short term interest rates sooner than the central bank would prefer in order to prevent a broad-based acceleration of inflation. Fear #1 is justified. Fear #2 is not.

The U.S. economy grew just 0.6% in the final quarter of 2007 and only 1% in the first quarter of this year. Sluggish growth is also expected for the quarter just ended, despite the stimulus provided by the federal tax rebate program. There are several factors currently weighing on the domestic economy. The most important of these are (1) deleveraging by consumers and financial institutions, (2) tight credit conditions and (3) the dramatic increase in oil prices.

Deleveraging. Over the last ten years total non-government debt increased at a record pace; fueling rampant speculation (e.g. the housing bubble) as well as above-average growth of consumer spending. Both financial institutions and consumers are now trying to rebuild their balance sheets. Unfortunately, history suggests that there is symmetry in every cycle of credit expansion and contraction. Because the credit bubble was inflated over many years, and because the deleveraging process is still in its early stages, the economy is likely to grow at a sluggish pace for a protracted period.

Tight Credit Conditions. All sectors of the financial industry (commercial banks, insurance companies, investment banks) continue to report large losses because of the housing bust. Moreover, home prices continue to decline because the supply of homes for sale greatly exceeds the demand. As home prices fall the value of securities linked to residential mortgages also continue to decline; further eroding the capital of financial institutions. This has lead to tighter credit conditions in the form of higher lending standards among banks as well as higher interest rates on many consumer and commercial loans – largely offsetting the efforts of the Federal Reserve to lower short term interest rates and improve liquidity in the credit markets.

High Oil Prices. The common perception among consumers and investors is that high oil prices lead to greater inflation because oil is a ubiquitous input in the global economy. Rapidly rising prices for gasoline and home heating fuels support that view. However, a more complete assessment leads to the conclusion that high oil prices are in fact deflationary. Just like an increase in taxes, high oil prices reduce both corporate profits and consumers’ purchasing power.

Deleveraging and tight credit conditions will likely persist well into next year. The outlook for oil is more complicated. The increase in oil prices over the last several years is supported by long term fundamental trends in supply and demand. However, there is strong evidence that the recent parabolic increase in the price of oil is due in large part to non-commercial participants in the oil markets; i.e. investors and speculators.

Simply put, the nearly 50% increase in the price of oil since the start of 2008 is not consistent with recent trends in supply and demand. Indeed, oil consumption appears to be falling in the developed economies and slower demand growth is likely in the developing countries as the economic slowdown becomes global. As with all asset bubbles, a sharp decline in oil prices is possible at any time. This would have obvious benefits for the real economy and would likely trigger a sharp increase in stock prices.

Because of the weak economy the Federal Reserve is likely to keep short term interest rates at low levels for an extended period so that banks can improve their profit margins and rebuild their capital. As noted above, many investors fear that high prices for oil and other raw materials will force the Federal Reserve to raise interest rates sooner rather than later in order to prevent higher inflation. Although headline inflation has accelerated, very few companies have the power to raise prices in a highly competitive economy. Moreover, the weak jobs market puts a cap on the growth of wages. Consequently, there has been very little leakage of higher oil and commodity costs into the prices of other goods and services. Core measures of inflation remain close to 2%. When the pace of economic growth begins to accelerate, perhaps in 2010, the Federal Reserve may have to move quickly to prevent core inflation from accelerating.

Stock prices are influenced by numerous variables in the short term. However, over the longer term share prices are driven by company profits and the value which investors are willing to place on those profits. Stock market valuations are largely determined by the current and anticipated level of inflation and interest rates. As noted above, the near term outlook for inflation and interest rates is benign. However, the outlook for corporate profits has clearly deteriorated.

After-tax profits of U.S. companies continue to grow at a mid-single digit pace, but this masks some critical differences among industries and sectors of the economy. The national income profit data is based on corporate tax returns and excludes the large “one-time” gains and losses which often distort the earnings reports of many companies. According to this government data, profits of foreign subsidiaries are up nearly 20% over the past year, due in part to the weaker U.S. dollar. Profits of most energy-related companies are also up sharply due to the spike in oil prices. However, profits among financial companies have declined more than 10% and the domestic profits of non-financial companies fell by 1% over the past year.

Foreign economies are now following the U.S. into a period of slower growth or recession. Profits of energy and commodity companies will be vulnerable if and when those bubbles collapse. If our assumptions about deleveraging and tight credit conditions are correct, then financial sector profits and the domestic profits of many non-financial companies will remain under pressure for a protracted period. The bottom line is that many Wall Street analysts and investors who expect profit growth to accelerate later this year and in 2009 will be disappointed.

The companies which dominate our clients’ portfolios are not immune to the business cycle but they are significantly less vulnerable. As the first quarter results of General Electric demonstrated, even the best managed and most diversified companies are capable of short term disappointments. Nevertheless, it is hard to imagine an economic environment which should be more favorable for our investment approach. We expect the largest holdings in our clients’ portfolios to achieve average profit growth of nearly 10% this year. Yet, as shown below, even companies which remain on track for double digit earnings per share (EPS) growth have experienced sharp declines in their stock prices.

Automatic Data Processing: March Quarter EPS Growth +18% Estimated 2008 EPS Growth +19 Share Price Year-to-date -6%

Sysco: March Quater EPS Growth +14% Estimated 2008 EPS Growth +13% Share Price Year-to-date -12%

Coca-Cola:March Quarter EPS Growth +20% Estimated 2008 EPS Growth +11% Share Price Year-to-date -15%

Stryker: March Quarter EPS Growth +21 Estimated 2008 EPS Growth +20% Share Price Year-to-date -16%

Pepsico:March Quarter EPS Growth +8% Estimated 2008 EPS Growth +10% Share Price Year-to-date -16%

3M: March Quarter EPS Growth +8% Estimated 2008 EPS Growth +10% Share Price Year-to-date -17%

Procter & Gamble: March Quarter EPS Growth +11% estimated 2008 EPS Growth +13% Share Price Year-to-date -17%

Our companies have benefited from the stronger growth of foreign economies and, as noted above, this tailwind will begin to fade. However, the profit growth of these companies is mostly a function of the attractive businesses in which they are engaged as well as their competitive positions within those businesses. Most of the companies in our clients’ portfolios enjoy relatively constant demand for their products and services; allowing for greater control of costs and producing steady improvement in profit margins. These companies also enjoy substantial customer loyalty and, therefore, can raise prices when necessary without sacrificing market share. Also, in most cases they require very little additional capital in order to expand production and distribution. Consequently, they return most of their profits to shareholders in the form of dividends and share repurchases.

In a sluggish economic environment, most investors gravitate to stocks with highly predictable profits and strong finances. The failure of the stock market to discriminate in their favor over the past few months is confirmation of the widespread investor fears discussed above. Although we continue to monitor critical variables such as economic growth, inflation and interest rates, we remain committed to a bottom-up strategy which seeks to identify superior businesses and purchase them at reasonable prices. As long as our companies continue to achieve steady and superior profit and dividend growth, then their intrinsic value is increasing. So too will their stock prices over time. This is a sensible investment approach in any environment, and an especially prudent strategy in the current environment.

Stryker may be the best example of disconnect between company performance and stock performance in recent months. On May 8 Stryker’s President and Chief Executive, Steve MacMillan, brought his senior management team to New York for a business review with the investment community. Mr. MacMillan assumed his position at the maker of orthopaedic implants and medical/surgical equipment at the end of 2004. Under his leadership Stryker has continued the record of strong profit growth which characterized the 28 years of his predecessor, John Brown.

Stryker has long pursued one overriding financial objective – 20% growth in earnings per share every year. In 1999 the company suspended this objective in order to acquire and successfully integrate Howmedica, the orthopaedic implant business of Pfizer. That acquisition, completed at the end of 1998, doubled the size of Stryker and provided the foundation for strong top line growth and consistent profit margin improvement over the last decade. From 1997 through 2007 the company achieved annual sales and profit growth of 20% and 23%, respectively.

The medical device business is highly profitable and requires very little incremental investment in plant and equipment. For example, Stryker’s capital expenditures in 1997 equaled 28% of net income. In 2007 capital reinvestment amounted to only 18% of net income. In fact, Stryker’s annual investment in plant and equipment is consistently less than the company’s depreciation and amortization. Consequently, the company has virtually no debt and $2.3 billion in cash – over 30% of total assets.

Like other large medical device companies (e.g. Johnson & Johnson, Medtronic) Stryker has used its strong cash flow for small acquisitions which broaden its product offering. However, we would not be surprised by another large acquisition similar to the Howmedica deal.

Stryker is the #3 supplier of hip implants (21% market share), the #3 supplier of knees (18%) and the #4 supplier of spinal implants (9%). Although the aging population provides a strong tailwind for growth, these markets have become more competitive in recent years following government investigations of industry pricing practices and the relationships between implant manufacturers and doctors who serve as consultants. Therefore, we would not be surprised if Stryker acquired a smaller manufacturer of hips, knees or spinal implants in order to leapfrog industry leaders Zimmer and DePuy (a unit of J&J). Much like the Howmedica deal ten years ago, such an acquisition would probably hold the potential for broader distribution and significant cost reductions. Indeed, Stryker’s after-tax profit margin rose from 12.6% in 1997 (the last full year before the Howmedica merger) to almost 17% in 2007.

Over the past few years the company has focused more on its existing businesses – increasing research and development costs much faster than sales and adding to its sales force. Consequently, Stryker’s highly profitable medical (hospital beds and stretchers) and surgical equipment businesses (endoscopic cameras, tools and instruments) have risen from 33% of total company sales to 40%. The slower growing hip and knee businesses have declined from 40% of total sales to only about one third today -- even though the company also divested its chain of physical therapy clinics. Today Stryker is a more balanced company and is better able to continue its financial progress despite short term disruptions in any one of its key markets.

Needless to say, Stryker’s long term growth record is one of the best among American companies. Inevitably such records become an albatross for the stock price; especially when management has embraced a specific financial objective, i.e. 20% annual EPS growth. Stock prices typically fall sharply when companies’ growth records come to a surprise ending. We believe Steve MacMillan is well aware of this risk to the stock price. Unlike John Brown, who believed in “20% forever,” Mr. MacMillan embraces the goal of “20% for as long as possible.” If and when this goal is not achievable, we believe Mr. MacMillan will avoid a painful surprise by articulating a realistic growth objective well in advance.

Charles Clark (207-775-1140) June 30, 2008

Michael Stuart (860-478-9012) S&P 500: 1280