2007 will be remembered as a year when excessive leverage caught up with reckless borrowers and lenders. Homeowners defaulted on subprime loans as the housing market finally turned, and some of the largest and most important financial institutions in the world had to go begging, cup in hand, for capital from Middle Eastern or Asian sovereign wealth funds. Surprisingly, in spite of significant problems in the banking system, most stock market indices managed to produce positive returns. For the year, the S&P 500 was up 5.5% and the Dow Jones Industrials rose 6.4%. The Russell 2000 fell 2.8%, marking the first decline in the small-stock index since 2002. The Baker Ellis Composite was basically flat in Q4; thanks to a good first half, the composite gained 16.5% for the year.*

Our performance benefited from minimal exposure to U.S. bank stocks during a year in which the financial sector of the S&P 500 fell 21% and household names such as Fannie Mae, Bear Stearns and Citigroup lost at least a third of their value. We have long been concerned that U.S. economic growth was due in part to an unsustainable and reckless expansion of credit, encouraged by the easy money policies of our Federal Reserve and inadequate regulation. Some bankers and investors seemed to view lending money at ridiculously low interest rates to poor credit risks as a sound business strategy. Although that business model may work while the economy is roaring and asset prices are rising, it is proving toxic in a slowing economy with declining collateral values.

We hope that the crisis spurs meaningful reform. Fannie Mae, Freddie Mac and the Federal Home Loan Banks could be fully privatized, with the federal government making it clear that it will not bail them out with taxpayer dollars. If government were less of a participant in the lending business, it could be a better regulator. Unfortunately, these reforms are not yet on the table. Instead, we were distressed to read reports that FHLB Atlanta loaned Countrywide Credit about $51 billion in the first three quarters of 2007, with Countrywide’s mortgages serving as collateral – a staggering sum to advance to a publicly traded company now battling rumors of impending bankruptcy.

We were not immune to the unfolding credit crisis. Swiss Reinsurance (SWCEF) took a hit when the company announced a large writedown on a policy it sold to protect a counterparty from losses tied to subprime mortgages. DBS Bank Ltd. (DBSDY), the largest bank in Singapore, announced a similar writedown. Real estate investment trusts as an asset class declined about 19% for the year, a truly dismal performance. Our shares of Cedar Shopping Centers (CDR) fared even worse.

Fortunately, our winners were more plentiful. The run-up in crude to $100 a barrel benefited our oil stocks, and our commodity plays were rewarding (though we wish we had not lightened up on them during the year). A few of our laggards also came through for us, most notably Berkshire Hathaway (BRKA/BRKB), which gained about 29% for the year. Our original thesis on Berkshire was that its true AAA balance sheet would be a competitive advantage at some point. We are pleased to see the thesis playing out as Chairman Warren Buffett recently announced plans to provide municipal bond insurance in competition with MBIA and other companies made vulnerable by their chronic underpricing of tail risk.

Buffett’s foray into the bond insurance business reminds us of why we are investment managers. Conventional wisdom among the investing public these days seems to be that picking individual stocks is too risky. Instead, investors flock to exchange-traded funds, funds-of-funds and “enhanced” index products. Similarly, large institutional investors now almost universally utilize consultants who steer them to a slew of managers whose performance closely tracks specific indices or, worse, “managers of managers” with an added layer of fees. Buffett is the opposite – he is willing to make most capital allocation decisions himself and does not feel the need to hire outside managers to run Berkshire’s stock portfolio. While we have always had a fondness in our hearts for a low-cost indexing strategy, investors who bought the Nasdaq index at its 2000 peak have half as much money today as they did nearly eight years ago – not counting inflation. We believe a good manager can add value by leaning in the direction of opportunity, and trying to avoid poor risk-reward scenarios.

Along those lines, we have not yet been tempted to pick through the rubble of the financial sector. While subprime losses may prove manageable to more capable lenders, a continued decline in real estate values could lead to a spill-over effect in credit-card receivables, auto loans and home-equity lines of credit. Adding to the risk are trillions upon trillions of dollars of lightly regulated derivatives. If banks are taking such large writedowns while the world economy is arguably as strong as it has been in our lifetimes – and with real estate and stock markets within 10% of all-time highs – we wonder what would happen in a nasty recession. If we are wrong, and the economy quickly recovers, our caution may lead to short-term underperformance.

The restructuring of Citigroup, Morgan Stanley and Merrill Lynch all involved the sale of equity to an investment entity controlled by a foreign government. As we have said before, huge trade deficits and the weak dollar are facilitating a gradual transfer of American wealth abroad. We see the potential for this to become increasingly controversial, particularly with our unprecedented transfer of technology, manufacturing and intellectual property to China. We have no doubt that China, which is now engaging in more aggressive diplomacy and military maneuvers, has greater long-term global ambitions than to sell us cheap manufactured toys.

We expect 2008 to be another volatile year, but volatility brings opportunities. Among our recent buys has been The New York Times Company (NYT). An abysmal stock for the past two years, NYT has dropped from 40 to under 20 as advertisers have defected from print newspapers to the Internet. Still, the company generates hefty cash flow, carries a 5.2% dividend yield at current levels and has a world-class reputation for gathering and reporting news. If consumers decide that they are not completely satisfied by watching YouTube videos of Britney Spears and trading friends on Facebook, we expect this leading franchise to find a way forward in the new world of media. In any event, we find its $2.3 billion market cap intriguing next to the current $203 billion valuation for Google.

Sincerely,

Brian C. Baker, CFA Barnes C. Ellis

P.S. The SEC requires us to offer you an updated copy of our Form ADV, Part II each year. This form contains information on our policies and business practices. If you would like a copy, please contact us and we will be happy to send you one. In addition, please find enclosed a copy of our Privacy Policy.

*Composite return represents accounts over $100,000 held at Fidelity Investments. Composite may exclude accounts with legacy positions or restrictions. Composite performance is size-weighted. Individual returns vary based on risk tolerance, timing of investment and other factors. Consult your performance report for details. Size-weighted dispersion for Q4 was 1.6%. Performance is net of fees. S&P index data includes gross dividends; other index returns are price change only. Investors cannot own an index, a hypothetical portfolio without fees or expenses. S&P 500 data provided for purposes of comparison only and may not be the most relevant benchmark. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results. Further information is available upon request.

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