CLARK & STUART, INC.

Investment Counsel

Dear Friends,

Given the recent extraordinary developments in the financial industry, we have again dispensed with the usual format of this quarterly letter. Instead, this report addresses the key questions we believe are on your minds at this critical moment. We know that many of you are watching the market closely and you may be nervous. We also know that most of you share our long term optimism in the American economy and our financial markets. If you need further reassurance, please do not hesitate to call us.

How has my investment account performed during this period?

Needless to say, 2008 has been a very difficult year for the stock market. Through the end of September the Standard & Poors 500 index has declined almost 21% (excluding dividends). On a total return basis the S&P 500 is down over 19% since the start of the year; including a loss of more than 8% in the third quarter.

Most of our clients will find that their portfolios are down substantially less than the market averages. For example, the composite of all clients’ accounts shows a decline of 10.6% since the start of the year and a gain of 2.3% in the latest quarter.

There is a very high level of commonality among our clients’ portfolios. However, your results may differ significantly due to the size of your account, large weightings in a few holdings, tax considerations, and the timing of contributions or withdrawals. Therefore, although our composite is an accurate measure of our performance, it is not as meaningful as the results for your portfolio.

These results are not satisfactory simply because our losses are less than the market averages. Moreover, we hold a few stocks which are down significantly. However, because we employ several conservative disciplines for the purpose of minimizing losses, we are very encouraged. Short term results are not very meaningful, but the longer term performance of your portfolio will benefit substantially if we are able to continue to minimize the declines in this bear market. Recognize, for example, that a loss of 20% will require a gain of 25% just to get even, while a decline of 10% requires a gain of only 11% in order to fully recover.

I make regular withdrawals from my account to supplement my income. Will my funds be available?

Yes. For clients who make regular withdrawals from their accounts, we monitor the cash balances carefully, we make sales opportunistically and we typically have several months of cash reserves available. We do not want to be in a position of having to sell stocks at a time like this when the market is under great stress.

Every financial firm must be able to return cash to its clients and customers when they ask for it. This is the foundation of trust and confidence in our financial system. Unfortunately, this imperative has been forgotten at several large institutions.

Couldn’t we just sell everything now and get back into the stock market later at a lower price?

This is easier said than done. We have repeatedly warned about the risks of market timing. History has shown that investors who try to time the market achieve lower long term returns because emotions lead them to sell near the bottom and buy closer to the top of market cycles. Our job is to stand in the way of those emotions.

Since the late 1920’s, a period which includes the Great Depression, World War II, several recessions, and numerous crises (e.g. the oil embargo in the 1970’s, the 1987 “market crash”, September 11, 2001) common stocks have provided long term returns better than 10% -- better than bonds, better than money market accounts, better than CD’s and, most important, much better than inflation. As pointed out in a recent report by our friend Bob DeLucia (Veritas Economic Analysis), “the truly remarkable statistic is that the long-term total rate of return on common stocks when omitting the 20 best performing days declines to a return that is less than one-half of the return enjoyed by buy-and-hold investors.”

Nevertheless, you should never commit funds to the stock market which may be needed in the short term for important needs such as paying for college tuition or buying a home. Therefore, if you have an important need for your assets, then we cannot argue with a decision to reduce your exposure to the stock market. However, it is not a good idea to sell when most other investors are panicking. These investors’ fears will fade and a better opportunity to sell will emerge.

Finally, consider this: In August 1987 the Dow Jones Industrial Average peaked at 2722. Two months later it fell by more than 20% in a single day. On Monday, September 29, the Dow fell 7% and closed at 10365. An investor who bought at the top in 1987, and sold at the bottom on Monday, would have still achieved an average annual return greater than 9%, including dividends, over the last 21 years. Time is the investor’s best friend.

What has been your investment strategy during this crisis?

We do not alter our fundamental investment approach because of short term market dynamics. However, it is always important to know what type of market we are in at the moment. Clearly, this is not a good market in which to sell. We believe this is a good market in which to buy – with patience.

Earlier this summer the market began to differentiate between stocks which are more speculative and the shares of tried and true companies. However, there are no safe havens during a true financial crisis. This is because many money managers at mutual funds and hedge funds will sell even the stocks they would prefer to buy simply because the investors in their funds want to get out. We are under no such pressure to sell and it is our natural instinct to buy when many others are forced to sell.

In most clients’ accounts we have been holding cash which was generated by the earlier sale of stocks such as Microsoft and Wrigley; waiting for a buying opportunity in specific companies which meet our standards. In recent weeks we have purchased the shares of two companies which we have owned in the past: Emerson Electric and Illinois Tool Works. Given their participation in global industrial markets, Emerson and ITW are much more exposed to the overall economy than the stocks which currently dominate our portfolios (e.g. Proctor & Gamble, PepsiCo, Johnson & Johnson, etc.). However, both EMR and ITW are down substantially from their highs; already discounting the potential impact of the global economic slowdown on their future results. From current prices, we expect these two issues to provide excellent returns over the next several years. We have made partial investments in these two companies and we are prepared to buy more at lower prices.

In summary, the current economic environment provides a significant opportunity for the companies we favor. Companies which exercise long lasting competitive advantages, particularly those which do not rely on the capital markets to finance their growth, will gain market share at the expense of weaker rivals during this recession. Our companies will be even better positioned when the next economic expansion begins.

I agree with your approach, but I am still nervous. How did our financial system end up in crisis?

Many factors contributed to the current crisis; far more than we can discuss with insight and clarity in a four page letter. Still, it is clear that this financial crisis has its origins in the excesses of the housing industry earlier this decade. The combination of extremely low interest rates and relaxed lending standards produced an explosion of low quality mortgages and mortgage-related securities. Ten years ago total household mortgage debt represented about 45% of U.S. gross domestic product. Today this ratio is nearly 70% and much of this incremental debt is held by people who cannot afford their monthly payments. One recent study indicated that almost 25% of the subprime mortgages taken out since January 2004 are now delinquent.

Another contributing factor was the false assumption that real estate values always increase. This myth, along with the availability of insurance against borrowers defaulting on their obligations (e.g. derivative instruments known as credit default swaps), motivated lenders to place too much emphasis on the underlying value of collateral (i.e. house prices) and not enough emphasis on the borrower’s ability to repay.

Also, the process of “securitization” – bundling together thousands of individual mortgages and other loans (autos, credit cards, etc.) – has had both positive and negative consequences. The principle benefits included a much larger pool of capital available to borrowers and a greater “dispersion of risk” across the financial system. However, this dispersion of risk now lies at the core of today’s banking crisis; no one knows for sure where the risks are. As Warren Buffet has said, “it’s only when the tide goes out that you learn who has been skinny dipping.”

2. This seems so obvious now. Didn’t anyone see this coming?

Despite our long term faith in the American economy, we try to maintain a skeptical view; watching for downside risks especially when other investors are exceedingly optimistic. Thus, we identified the cause and consequences of today’s crisis over three years ago:

“Every asset bubble represents a misallocation of resources, but the economic consequences of the real estate bubble will be more severe because homes are a non-productive asset. When the bubble eventually leaks the economy will be impacted by reduced consumer spending and a higher number of bad loans on the books of banks and other mortgage lenders.” (July 5, 2005)

We were not alone with this observation. Still, we do not know anyone, including us, who predicted the events of the past several weeks.

Wall Street uses a lot of jargon that I do not understand. Specifically what is “moral hazard”?

“Moral hazard” is the notion that investors should not be saved or “bailed-out” because doing so will only encourage others to assume even greater risks in the future. In dealing with this crisis, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and FDIC Chairwoman Sheila Bair have been keenly aware of moral hazard. However, the first priority is avoiding a complete breakdown of the banking system. That is why the operations of companies such as Fannie Mae, Freddie Mac and AIG have been rescued in a manner which has essentially wiped-out the shareholders. Similarly, depositors have been protected but shareholders have been punished in the takeovers of Washington Mutual and Wachovia which were arranged by the Federal Deposit Insurance Corporation. Finally, the shareholders of Lehman Brothers, which was not rescued by policy-makers, were completely wiped-out.

I understand the concern about moral hazard in the current crisis, but it seems to me that past mistakes, in policy and in regulations, may have encouraged excessive risk-taking. Is this true?

We agree. Several past policies and practices, in Washington and on Wall Street, contributed to this financial crisis. These include: (1) the tendency of the Federal Reserve under Alan Greenspan to cut short term interest rates swiftly and significantly in response to almost every crisis; (2) regulatory changes which allowed investment banks to assume $25-$30 of debt for every $1 of capital, and (3) well-intentioned but miss-guided support from Congress to Fannie Mae and Freddie Mac to promote affordable housing through massive purchases of subprime mortgages. Going forward, significant improvements in financial regulations are needed. However, resolving the immediate problems in the credit markets should be the top priority of policy-makers.

O.K., but what is appropriate role for the Federal government in this crisis? Specifically, can you explain why the $700 Billion plan before Congress is not just a bail-out for Wall Street?

It may be a good thing for an individual consumer or a company to reduce its debt. But widespread de-leveraging has the perverse effect of driving down the value of assets which are being sold in order to pay off debt. When the entire financial system seeks to de-lever, there is only one institution in the world which has the resources needed to purchase those assets – the U.S. Treasury.

A second and more immediate problem is the evaporation of trust in the banking system. Banks are reluctant to lend to each other because they do not trust one another’s books. Consumers are withdrawing their accounts because they do not trust their banks to make good on deposits. Consequently, businesses, schools, hospitals and local governments are paying a high price for the short term credit which funds their daily operations and are at risk of losing access to credit altogether.

Even the most fervent believers in free markets agree that government plays an important role in sustaining a healthy financial system in order to promote economic growth. Unfortunately, many Americans do not understand the linkages between the financial system and our personal circumstances. In truth, there is no daylight between the well-being of Main Street and the success of Wall Street. Almost 70% of Americans own a home. Over 50% of Americans own common stocks – either directly or through mutual funds. Only a small percentage of Americans do not have a bank checking or savings account. We, the homeowners, the shareholders, and the depositors are also the taxpayers. We have no greater economic self-interest than the preservation of a healthy financial system.

3. The actions taken in recent weeks by the Federal Reserve, the Treasury, and the FDIC have mostly addressed the symptoms of this crisis. The rescue plan proposed by Treasury Secretary Paulson is targeted at the fundamental problems. By purchasing illiquid mortgage-related assets from financial institutions, this program will have two key benefits: (1) it will remove much of the risk and uncertainty which has frozen many sectors of the credit markets, and (2) it will encourage private investors to help rebuild the capital of financial firms so that normal lending can resume. Recent investments by Warren Buffet in GE and Goldman Sachs are a good example.

Most important, this program is not an expenditure. Rather, it is a purchase of assets at distressed prices and a vote of confidence in American homeowners. When these assets are later sold for a higher price, or held by the Treasury until they mature at higher values, then the Treasury will recover most of the purchase price. In fact, if these assets are purchased at the right price, then the Treasury may realize a substantial profit.

However, the Paulson Plan is not a panacea for the economy in the short term. As discussed below, economic conditions are likely to deteriorate in the months ahead. (Note: As we write this report, the Paulson Plan remains in limbo because it was rejected by the House of Representatives on September 29.)

What, then, is your outlook for the economy and do you believe that we could have a depression?

The starting dates and ending dates of recessions are determined by a panel of independent economists: the National Bureau of Economic Research. Their determinations are often made well after the fact. We expect the NBER to conclude next year that the economy has been in recession for most of 2008. Given the additional stress on the economy from the current financial crisis, we expect the recession to continue well into next year. Unemployment will rise, corporate profits will fall and more institutions will fail. Also, as we discussed in previous reports, the unwinding of excess debt by consumers and financial institutions will remain a significant headwind for the economy when the next economic expansion begins.

Slower growth in foreign economies, whose financial institutions have also been damaged by the credit crisis, will be another headwind. In recent years many investors bought into the “de-coupling” thesis; i.e. the notion that foreign economies, particularly fast growing countries like China and India, would be immune to a slowdown in the U.S. This theory is rapidly losing credibility.

There are, however, a few silver linings. Inflation pressures are rapidly easing. Slower economic growth, particularly in Asia, has reduced demand for oil and other industrial commodities. The benefit to American consumers at the gas pump is obvious. Many corporations will also enjoy some relief on their profit margins due to lower commodity costs. Finally, lower inflation will allow the Federal Reserve to keep short term interest rates at very low levels. However, given the actions necessary to save our financial system, significant inflationary pressures are possible after the economy begins to recover – perhaps in 2010.

We do not believe the economy is on the precipice of a depression. The current financial situation is serious and leaders like Mr. Paulson and Mr. Bernanke have made clear the consequences if our political leaders fail to take necessary actions. Indeed, the Depression of the 1930’s was largely a result of serious policy mistakes. Our economy is much different today; more diverse and more resilient. Also, our understanding of the impact of monetary and fiscal policies on the economy is far more advanced. Finally, the non-financial corporate sector is very healthy. Profit margins are high and balance sheets are strong. Moreover, because many firms were cautious during the last expansion, severe cutbacks in employment and capital investments are unlikely. Nevertheless, the risks to the economy are significant. Failure to resolve this crisis quickly will result in a deeper and protracted recession.

Can you summarize the key points in this report?

1. Despite the sharp decline of stock prices in general, our clients’ losses are much smaller.

2. After several responses to the symptoms of this crisis, policy-makers are now moving aggressively to address the fundamental problems and to accommodate the necessary de-leveraging of the financial system.

3. An economic disaster should be avoided if Congress provides the U.S. Treasury with the necessary tools.

4. We continue to execute our fundamental investment approach; purchasing companies with long-lasting competitive advantages while their stock prices are under pressure. The financial crisis and the deteriorating economic backdrop provide significant market share opportunities for companies we own.

Charles Clark (207-775-1140) Sept. 30, 2008

Michael Stuart (860-478-9012) S&P 500: 1165