Fourth Quarter, 2007

"When the facts change, I change my mind. What do you do, sir?."

— John Maynard Keynes

The last five months of 2007 witnessed a sea change in U.S. financial markets. Housing-related credit concerns led to gigantic write-offs and even rumors of insolvency at major U.S. banks, brokers and other financial concerns. While we have seen worse markets, we cannot recall a period where sentiment changed so quickly. We entered 2007 with a long-held, large position in financial stocks. These investments were well-reasoned, thoroughly-researched and, in this market environment, terribly wrong. Our financial concentration cost the portfolio 10% of return in 2007 and was the sole factor that kept us from beating the S&P 500 Index for an eighth consecutive year. Even though the portfolio contained more than a third financial stocks, we still managed to finish about flat for the year. We are not pleased with this result, but the downdraft in the financials did obscure the strong performance of many of your other investments, especially in the energy, food and technology sectors. Our investment process led us to respond to what we believe are changing facts, not just increased negative sentiment, and we took the advice of Mr. Keynes quoted above by reducing the financial weighting in the portfolio by almost two-thirds. The effect has been strong performance: As of January 8th the portfolio is up about 2.5% since we finished reducing our financial weighting in mid-November, with the market down more than 3%. This letter describes the stocks driving the current outperformance, and why we think they should continue to perform well in the new year. In the last part of the letter we also discuss in detail (perhaps too much detail for some) how our investment process operated during this complex period.

A Portfolio Looking Towards 2008

Out of turbulence comes opportunity. The current economic worries are partly caused by the rising price of oil and other commodities. Our bottoms-up approach has identified a number of inexpensive companies in the capital goods, food, energy and electricity sectors. We buy each company on its individual merits, but all of these are united by one theme: scarcity of resources, brought about by a world that is thriving and developing in all sorts of places previously left behind. This investment theme is especially important if you think, as we do, that the U.S. economy will slow in 2008. We believe that investments that benefit from an increasing scarcity of resources can continue to prosper in a slowing environment.

Everyone knows about the rising price of oil, and we made a lot of money from 2003 onwards owning oil and gas companies. We think many of those ‘pure plays’ have become fully valued, so we have gone further upstream to take advantage of the wealth created by these higher prices. Capital goods companies like Foster Wheeler (up 784% since purchase three years ago) and KBR (up 79% since purchase in March) build new energy facilities like refineries, liquefied natural gas plants and pipelines. They also refurbish – for billions and billions of dollars – existing facilities. Almost none of their business is in the United States, and the government-controlled (read: good credit) energy companies that are their customers are flush with cash after a generation of underspending on infrastructure. This is a cycle that should last for a half decade at least.Another play on scarcity, Archer Daniels Midland, is a new addition to the portfolio in 2007 and is up 34% since purchase. We believe it will benefit from a multi-year increase in the cost of grains worldwide. ADM is the largest public company in the middle of this transformation. The bad press on ethanol over the past six months has given us the opportunity to own the stock cheaply. Less than 10% of ADM’s profits come from ethanol, but almost 40% in the last quarter came from storing, moving and selling grain. The other 60% comes from transforming raw grain into something else, like high fructose corn syrup, soybean oil, cocoa and the controversial ethanol. As we know first hand from our successful investment in the oil refiners several years ago, counter-intuitively, these “transformers” can grow their earnings sharply when the cost of their raw material rises sharply. If the cost of corn or wheat double, for example, when ADM is eventually able to pass on that cost and simply restore margins to where they were in the first place, profits do not simply return to normal, they double as well.

Finally, Dynegy, a new addition to the portfolio that is down 21% since purchase, represents another play on the scarcity of resources, the limited availability of electricity. Dynegy is the fourth largest independent power producer in the United States with over 20,000 megawatts of generating capacity. As the CEO put it the other day, when it comes to the possibilities of building a new power plant in the United States, there are two categories: the extremely difficult and the impossible. In other words, as the nation’s electricity usage continues to inexorably increase, the supply of power cannot keep up. We believe the cost of providing that power will have to increase. While the stock is down, it is extremely volatile and we own the stock because we think it will eventually trade at its underlying asset value, which would represent appreciation of close to 100%.

As we look toward 2008, it is worth pausing to mention that we have increased the cash position in the portfolio. This is a direct result of the sale of the financial positions, coupled with the lack of what we feel are compelling opportunities in the marketplace. Rest assured we continually research new ideas, and will deploy this cash, but only when we feel the potential rewards outweigh the many risks in today’s market environment.

We did find one new investment late in the fourth quarter that passed this risk/reward test: Cisco Systems. Cisco is the world’s largest manufacturer of internet communications equipment, and its routers and switches form the synapses of much of the global communication network. If you deduct the roughly $2.60 per share in net cash (after paying off all debt) on Cisco’s balance sheet, the stock is trading for a bit more than 14 times 2008 earnings, and 12 times earnings for 2009. That is close to a record low for Cisco, brought about because investors are afraid a U.S. economic slowdown will cause the company to miss its earnings targets. With 47% of Cisco’s sales now coming from outside the United States, and the company continuing to take market share in important product categories, we believe the company can live up to its projections, even if the U.S. economy does slow. Last year they were able to grow revenue 23% and earnings 27%, no mean feat for a company with annual sales of more than $35 billion. Further, we have known this management team for more than 10 years, having successfully invested with them from 1997 to early 1999, and they get top marks in terms of competence and honesty. Finally, this is one of the strongest balance sheets of any U.S. company, with conservative accounting and solid corporate governance. We are pleased to be able to buy in at what we believe is an attractive price.

A Review of our Process in 2007

While all portfolio managers like to brag about their winners, we believe it is more informative to understand how they handle investment choices that do not work out as planned. As contrarians, we often invest early in companies that ultimately reward us in the long term. Financial stocks have often represented a large portion of our portfolio, and in 2005 and 2006 we were increasingly attracted to their low price/earnings ratios and high dividends. We believed that rising interest rates were hurting these stocks, but eventually the Federal Reserve would be forced to ease and these stocks would emerge with the twin tail winds of falling rates and low valuations. We were not oblivious to the approaching credit cycle, and our financial models contained provisions for record-high, but still manageable, losses. We knew our companies extremely well, and it is against our style to sell when the going gets tough. Why then, did we sell many of our financial stocks? At the risk of devoting too much ink to the inner workings of our process, we think it is important to detail how we decided to cut our losses in some of our financial investments instead of maintaining or even increasing our weighting as some managers have done, and as we have done in other instances in the past.

Giving up on a losing investment is perhaps the hardest decision we ever make, but our process is straightforward. Every investment has a thesis at its inception, supported by facts and inferences drawn from our research that, in our opinion, will lead to at least a 50% rise in the price of the stock over a three-year period. As time passes, and our companies report earnings, buy back stock, make acquisitions, and take a myriad of other corporate actions -- and as the macro-economic environment changes -- we continually revisit our thesis. One case in point is a stock that lost our clients money in 2007, MGIC Investment Corp. Early in the year this well-run mortgage insurance company was trading near book value for the first time. We knew the company well from an investment in the late-90s, and respected the management. In a process that took about six weeks, we undertook extensive research into the mortgage insurance market, visited the company in Milwaukee and developed our own financial models, all prior to making the investment. The investment thesis posited that, while more mortgage losses were coming, the stock, already down 40% from its peak, reflected the manageable losses we were modeling. Soon earnings would stabilize and business would grow faster than previously, because the fly-by-night mortgage brokers that had stolen share from MGIC would fade away as losses increased. An important part of the thesis was MGIC’s plans to merge with a competitor, Radian, and sell a successful joint venture of theirs called C-BASS (a company that bought and sold mortgage securities) for $1 billion, or more than 10% of the market capitalization of the combined companies. All told, we estimated that MGIC was about 60% undervalued. Our visit with management supported each part of our investment thesis, and in fact the CEO thought our loss assumptions were too conservative, as they were more pessimistic than MGIC’s internal estimates. There are many, many details which we omit here for the sake of brevity, but the stock price declined sharply in the third quarter due to the inability of C-BASS to ‘roll its paper’ or refinance its short term debt, a circumstance completely at odds with the history of MGIC, a company that was rated A1 by Moody’s.

The credit crunch was upon us, as the same liquidity concerns affected many financial companies, from Countrywide Financial to Citibank. The value of C-BASS, which as recently as a month before was estimated by us, the company and the marketplace at around $1 billion, was suddenly written down to zero, a stunning reversal. We did not model for this event (nor are we aware of anyone else who did), and this fact obviously flew in the face of our investment thesis. We struggled to find out whether this was a temporary liquidity problem or a more fundamental issue foreshadowing large, impending mortgage losses. At about the same time, we attended a previously scheduled meeting with the management of portfolio holding American International Group. At these meetings, AIG’s management disclosed that its own mortgage insurance subsidiary was experiencing ‘unprecedented losses’. Now, for AIG this was not a significant event, because its small subsidiary was not a material part of that financial conglomerate. But if MGIC were experiencing the same level of losses, our thesis would be disproven. MGIC was unwilling to disclose to us their current loss levels (and in fairness could not disclose them to us without making a mass disclosure to all investors). We made the inference that the facts supporting our investment thesis had changed dramatically. We sold the stock at a loss of almost 40% (it is since down 26% more after details began to emerge of large losses). That loss, as regrettable as it was, saved us money elsewhere: further research began to show that mortgage losses were rising much faster and each individual loss was more severe than we had forecast. That in turn led us to sell portfolio holdings Washington Mutual and Capital One at slight losses. Since their sales, these stocks are down 65% and 33% respectively.

We also revisited each of our other financial holdings, examining the underlying investment thesis and whether, in this new environment of deep and prolonged housing losses, they still merited our support. A number of the remaining financial investments failed the test and were sold, but we were not indiscriminate. We believed that AIG, down 16% in the second half and 11% since our initial purchase in 2006, was being unfairly punished. AIG does have mortgage exposure in its investment portfolio and some of its subsidiary businesses, but unlike the companies we sold, AIG does not have a capital crisis, as evidenced by the recent dividend increase (as contrasted with the sharp dividend cuts of many companies in the financial sector), continued stock buyback program, and the company’s recent statements that they have too much capital and are evaluating ways to return it to shareholders. Because of market events, the stock is trading at 8 times earnings and close to book value, valuations not seen in twenty years. We think this is an opportunity, and we have increased our investment in that company.

2007 also saw a large takeover in the portfolio, as Trane was acquired by Ingersoll Rand and the stock surged 23% on December 17th. This was part of our investment thesis and we were pleased to have it work out before year end. Ingersoll’s attraction to Trane is not an aberration. We are seeing low valuations in many sectors of the market that have not been observed in at least five years. Risk is high, and so far we have bought only the Cisco Systems in the last three months, but we are excited about the research we are currently undertaking and look forward to reporting back to you in the first quarter with the fruits of that labor.

We appreciate your support in 2007, and we again want to emphasize that each of the investment professionals at Grisanti Brown & Partners has the great majority of his investable net worth in the same stocks that we own for our clients. We have included a recent article about Grisanti Brown & Partners appearing in Value Investor Insight,in which a number of our investment ideas are highlighted at great length, should you be interested in learning (even more) about the portfolio. Finally, we have changed the name of our mutual fund (formerly the Steepleview Fund) to the Grisanti Brown Value Fund (symbol: GBVFX). It is for investors with less than our $5,000,000 minimum for a separate account or for those who for any reason prefer the fund format. Its fees are competitive with our larger product and it is managed with the same portfolio.

We wish you a happy and prosperous new year.

Grisanti Brown & Partners LLC