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[SOURCE CAPITAL, INC. LOGO]
SOURCE CAPITAL, INC.
THIRD QUARTER REPORT
September 30, 1995
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OFFICERS AND DIRECTORS
[SOURCE CAPITAL, INC. LOGO]
SOURCE CAPITAL, INC.
<TABLE>
<S> <C>
DIRECTORS CUSTODIAN
Wesley E. Bellwood State Street Bank and Trust Company
George H. Michaelis Boston, Massachusetts
David Rees
Lawrence J. Sheehan COUNSEL
Charles W. Stanton O'Melveny & Myers
Kenneth L. Trefftzs Los Angeles, California
TRANSFER AND SHAREHOLDER
SERVICE AGENT
OFFICERS Chemical Bank
George H. Michaelis, President J.A.F. Building
Christopher Linden, Senior Vice President P.O. Box 3068
Eric S. Ende, Senior Vice President New York, New York 10116-3068
Julio J. de Puzo, Jr., Treasurer (800) 279-1241 or (212) 613-7427
Sherry Sasaki, Secretary
Christopher H. Thomas, Assistant REGISTRAR
Treasurer Chemical Bank
New York, New York
INVESTMENT ADVISER STOCK EXCHANGE LISTING
First Pacific Advisors, Inc. New York Stock Exchange:
11400 West Olympic Blvd., Suite 1200 Symbols: SOR Common Stock
Los Angeles, California 90064 SOR+ Preferred Stock
</TABLE>
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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
As we recall our high school physics, Newton's law relating to momentum went
something like "Bodies in motion remain in motion; bodies at rest remain at
rest." This principle can be paraphrased as "You can't turn a moving battleship
on a dime." Supported by rising profits and falling interest rates, this year's
bull market in equities offers an apt example of this "moving battleship"
phenomenon as prices continued their advance in the most recent quarter
producing the best nine months returns since 1987 and the best trailing twelve
months results since calendar 1991.
During the most recent quarter, Source Capital's total net assets increased to
$359,678,348 from $350,032,835 at mid-year. Net asset value per Common Share
increased to $42.25 at September 30, 1995 from $41.09 at June 30, 1995. This
increase is after payment of a $0.90 cash distribution during the quarter.
INVESTMENT RESULTS
In the most recent quarter, Source Capital's net asset value per share of
Common Stock increased 5.1% while total net assets gained 4.6% with both
comparisons reflecting reinvestment of dividends and distributions paid during
the period. In comparison, the Standard & Poor's 500 Stock Average increased
8.0% during the quarter, also on a reinvested basis.
For the nine months ended September 30, 1995, the net asset value of Source
Capital Common Stock increased by 17.2% including reinvestment of distributions
paid during the period, while total net assets gained 15.4%. These increases
compare with a total positive return of 29.8% on the Standard & Poor's 500 Stock
Average.
NET INVESTMENT INCOME
Net investment income totalled $2,371,074 for the third quarter and $7,773,799
for the nine months, decreases of 16.4% and 7.9%, respectively, from the
corresponding periods of 1994. After providing for Preferred dividends, net
investment income per Common Share amounted to $0.17 and $0.59 for the quarter
and nine months, respectively, compared with the $0.24 and $0.72 earned in the
corresponding periods of 1994.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $0.90 per share was paid on
September 15, 1995 to shareholders of record on August 25, 1995. Source's 10%
Distribution Policy, adopted in 1976, calls for payments to Common shareholders
approximating 10% of the Common Stock's ongoing net asset value. Shareholders
are reminded that these payments substantially exceed the Company's net
investment income and thus represent a continuing payment of a portion of the
Company's capital. As we repeatedly point out, maintenance of the current $3.60
Common distribution rate is dependent upon achieving investment results which
will sustain a net asset value of approximately $36.00.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on September 15,
1995 to shareholders of record on August 25, 1995. Asset coverage on the
Preferred shares was 664% on September 30, 1995, compared with 646% at June 30,
1995 and 608% at year-end 1994. Net investment income provided Preferred
dividend coverage of 201% in the third quarter and 219% for the nine months of
the current year, compared with 240% and 238%, respectively, in the
corresponding periods of 1994.
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MARKET PRICE OF SOURCE CAPITAL SHARES
After increasing from $37 to $40 1/2 in the first half of 1995, the market
price of Source Capital Common Stock increased to $41 1/4 at September 30, 1995.
This $0.75 increase in market price was less than the $1.16 gain in net asset
value during the quarter. As a result, the market discount from net asset value
increased to 2.4% at September 30, 1995 from 1.4% at mid-year. The market price
of Source Capital Preferred Stock increased from $27 3/4 to $27 7/8 during the
quarter.
COMMENTARY
Four and a half years ago in the spring of 1991, John C. Bogel, the CEO of The
Vanguard Group, published an initial article in the Journal of Portfolio
Management entitled "Investing in the 1990s: Remembrance of Things Past and
Things Yet to Come." In that article, Bogel set out "a simple methodology for
analyzing long-term total returns on financial market assets." For stocks, he
concluded that "total returns could be explained largely by the
interrelationship of three components: (a) the initial dividend yield, (b) the
rate of earnings growth during the period, and (c) the annualized impact on
total return that results from any change in the price/earnings multiple during
the period." A second article followed in the fall of 1991 in which Bogel
actually used this model to forecast future returns for the decade of the 1990s
(1990-1999). His analysis only came to our attention recently by reading his
follow-up article, "The 1990s at the Halfway Mark," published in the summer 1995
issue of the Journal of Portfolio Management. However, his approach of analyzing
long-term future equity returns in terms of the contribution from each of the
three factors -- yield, growth and change in valuation -- is exactly parallel to
that initially explored in our 1994 Semi-Annual and Annual Report Commentaries
and revisited in the 1995 Semi-Annual Report.
In combining yield, growth and revaluation to make his forecasts in 1991,
Bogel decided to eliminate all subjectivity from the process. Yield is of course
of known quantity, and growth over long periods has not varied widely. The third
factor, predicting valuation, is inherently speculative because the historical
range of valuation has been so wide. Bogel's approach is ingenious, simple and
logical. For growth, he utilizes the average of the prior thirty years, and
deals with valuation by assuming that the price/earnings ratio at the end of his
ten year forecast will regress to the average of the prior thirty years. The
application of this methodology produced the following forecast for equity
market returns for the decade of the 1990s.
<TABLE>
<CAPTION>
Component 1990-1999
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<S> <C>
Initial Yield 3.1%
Earnings Growth* 6.6
Change in Valuation** (1.0)
---------
Total Investment Return 8.7%
* Earnings growth 1960-1989
** Impact of P/E ratio declining from
15.5 to the 1960-1989 average of 14.0
</TABLE>
While we will have to wait another four years to render a final judgment on
the ultimate accuracy of this 1991 forecast, it is notable that returns for the
first half of the period (1990-1994) were exactly 8.7%! Bogel acknowledges "that
luck, pure and simple, played a role in the virtually exact correspondence of
the forecast and actual returns." However, examining the results of all
thirty-four moving ten-year periods from 1948 through 1990 produced a
correlation of +0.78 between forecasted and actual returns (note: a correlation
of +1.0 would indicate a perfect forecast record). Examination of the actual
data presented in the current article reveals that the correlation of actual
with forecast returns
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seems notably higher in the most recent fifteen years than previously. One might
expect that the thirty year averages of growth and valuation data would be more
relevant and reliable once the data of the 1930s and 1940s is excluded. In any
event, it is impossible to ignore the inherent logic and the outstanding
forecasting record of this model.
Bogel has updated his 1990-1999 forecast based on data as of December 31, 1994
which yields the following result:
<TABLE>
<CAPTION>
Component 1995-2004
--------- ---------
<S> <C>
Initial Yield 2.9%
Earnings Growth* 6.4
Change in Valuation** (0.9)
---------
Total Investment Return 8.4%
* Earnings growth 1965-1994
** Impact of P/E ratio declining from
15.7 to the 1965-1994 average of 14.3
</TABLE>
This year's sharp market advance has driven the initial yield down to a
current level of 2.5%. Since neither the trailing thirty year averages of
earnings growth nor price earnings ratios are likely to have changed much with
the passage of nine months, a current forecast based on Bogel's methodology
would likely result in an estimated total return of about 8.0%.
As we initially pointed out, this approach to analyzing long-term equity
returns in terms of the three components of yield, growth and change in
valuation is identical to that which we presented in last year's Annual Report.
While Bogel uses long-term historical data to project future growth and future
valuation levels, we attempted to use judgment in supplementing pure historical
extrapolation of past growth rates. Further we ignored the tendency of valuation
levels to regress to the mean and simply assumed current valuation levels would
be sustained. Despite these differences, our conclusions are, not surprisingly
quite similar to his. As we expressed in the recent Semi-Annual Report, "the
high end of likely equity returns seems realistically limited to 8.5% to 9.0%."
Bogel's original articles forecasting 8.7% stock market returns over the 1990s
were published in 1991. In that year, equity returns exceeded 30%. Nevertheless,
his 8.7% forecast turned out to be right over the first half of his forecast
decade. Now he has updated his forecast to 8.4% over the decade 1995-2004, and
the first year again is producing results well over three times his forecast.
Just as the notably above-average returns in the year 1991 did not invalidate
the ultimate accuracy of the long-term forecasts Bogel made in that year, we
doubt that this year's sharp gains will prove sufficient to derail the ultimate
accuracy of his updated forecast.
The ultimate point of these articles is not to simply make predictions, but to
point out that if reasonably reliable long-term forecasts are possible, they
should help focus investors attention on appropriate long-term investment
strategies. For us, that message translates into continued focus on businesses
with enduring competitive advantages capable of earning above-average returns on
capital over the long-term.
Respectfully submitted,
/s/ GEORGE H. MICHAELIS
-----------------------------
George H. Michaelis
President
October 24, 1995
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MAJOR PORTFOLIO CHANGES
Quarter Ended September 30, 1995
<TABLE>
<CAPTION>
Shares or Ownership at
Principal Amount September 30, 1995
---------------- ------------------
<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Arbor Drugs, Inc. ....................... 208,800 shs. 208,800 shs.
Bandag, Incorporated (Class A)........... 22,300 shs. 236,600 shs.
Bob Evans Farms, Inc. ................... 73,000 shs. 249,200 shs.
Caraustar Industries, Inc. .............. 118,200 shs. 118,200 shs.
Carnival Corporation (Class A)........... 54,700 shs. 187,600 shs.
Cooper Tire & Rubber Company............. 78,500 shs. 216,400 shs.
JP Realty Inc. .......................... 75,000 shs. 153,800 shs.
Lancaster Colony Corporation............. 30,300 shs. 130,300 shs.
Norwest Corporation...................... 33,900 shs. 85,000 shs.
Progressive Corporation, The............. 77,700 shs. 77,700 shs.
CONVERTIBLE SECURITIES
Diagnostic/Retrieval Systems, Inc.--9%
2003................................... $1,500,000 $1,500,000
Fabri-Centers of America, Inc.--6 1/4%
2002................................... $2,465,000 $7,000,000
Quantum Health Resources, Inc.--4 3/4%
2000................................... $5,265,000 $5,265,000
NON-CONVERTIBLE SECURITIES
Federal Home Loan Mortgage Corporation
--8 1/2% 2024.......................... $3,000,000 $3,000,000
Government National Mortgage Association
(REMIC)
--7.99125% 2010........................ $3,829,600 $3,829,600
Kidder Peabody Mortgage Assets Trust
--8.45% 2018........................... $2,000,000 $2,000,000
NET SALES
COMMON STOCKS
EXEL Limited............................. 137,400 shs. --0--
First National Bank of Anchorage, The.... 980 shs. 5,340 shs.
Guinness PLC............................. 470,000 shs. --0--
Mercantile Bankshares Corporation........ 198,250 shs. --0--
Minnesota Mining and Manufacturing
Company................................ 83,100 shs. --0--
TBC Corporation.......................... 374,100 shs. --0--
VF Corporation........................... 100,600 shs. --0--
Wachovia Corporation..................... 42,400 shs. 87,400 shs.
Walgreen Co. ............................ 58,000 shs. 152,600 shs.
CONVERTIBLE SECURITIES
Amsco International Inc.--4 1/2% 2002.... $4,750,000 --0--
Hanson PLC--9 1/2% 2006.................. $1,000,000 --0--
McKesson Corporation--4 1/2% 2004........ $2,000,000 --0--
NON-CONVERTIBLE SECURITIES
Nabisco Brands, Inc.--6.8% 2001.......... $4,000,000 --0--
United International Holdings, Inc.--0%
1999................................... $4,420,000 $6,245,000
</TABLE>
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COMPOSITION OF TOTAL NET ASSETS*
September 30, 1995
<TABLE>
<S> <C>
Investment securities (cost $258,674,390):
Common stocks............................................. $235,474,819
Convertible securities.................................... 31,618,779
Non-convertible securities................................ 47,131,497
------------
$314,225,095
Cash, receivables, short-term corporate notes, less
liabilities............................................... 45,453,253
------------
Total Net Assets at September 30, 1995...................... $359,678,348
===========
Assets applicable to Preferred Stock at a liquidation
preference
of $27.50 per share (asset coverage 664%)................. $ 54,153,330
===========
Net Assets applicable to Common Stock -- $42.25 per share... $305,525,018
===========
</TABLE>
SUMMARY FINANCIAL INFORMATION*
<TABLE>
<CAPTION>
For the Periods Ended September 30, 1995
-----------------------------------------------
Nine Months Three Months
---------------------- ----------------------
Total Per Total Per
Net Common Net Common
Assets Share Assets Share
------------ ------- ------------ -------
<S> <C> <C> <C> <C>
Beginning of period.......... $329,426,748 $38.52 $350,032,835 $41.09
Net gain on investments,
realized and unrealized.... 41,836,540 5.84 13,599,125 1.89
Common shareholders only:
Income available........... 4,229,217 0.59 1,189,546 0.17
Quarterly distributions.... (19,372,599) (2.70) (6,480,413) (0.90)
Proceeds from shares issued
for distributions
reinvested................. 3,558,442 -- 1,337,255 --
------------ ----- ------------ ------
Net changes during period.... $ 30,251,600 $ 3.73 $ 9,645,513 $ 1.16
------------ ------ ------------ ------
End of period................ $359,678,348 $42.25 $359,678,348 $42.25
=========== ====== =========== ======
</TABLE>
<TABLE>
<CAPTION>
Dec. 31, 1994 June 30, 1995 Sept. 30, 1995
------------- ------------- --------------
<S> <C> <C> <C> <C>
Common market price per share........ 37 40 1/2 41 1/4
Common market discount from net asset
value.............................. 3.9% 1.4% 2.4%
Preferred asset coverage............. 608% 646% 664%
Preferred market price per share..... 26 5/8 27 3/4 27 7/8
* The financial information included in this report has been taken from the records of
the Company without examination by independent auditors. Securities are carried at
market value.
</TABLE>
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SOURCE CAPITAL, INC.
11400 West Olympic Boulevard, Suite 1200
Los Angeles, California 90064
