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LOGO
SOURCE CAPITAL, INC.
THIRD QUARTER REPORT
September 30, 1996
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<TABLE>
<S> <C>
DIRECTORS CUSTODIAN
Wesley E. Bellwood State Street Bank and Trust Company
Julio J. de Puzo, Jr. Boston, Massachusetts
David Rees
Robert L. Rodriguez COUNSEL
Lawrence J. Sheehan O'Melveny & Myers LLP
Charles W. Stanton Los Angeles, California
Kenneth L. Trefftzs
TRANSFER AND SHAREHOLDER
SERVICE AGENT
OFFICERS ChaseMellon Shareholder Services, LLC
Julio J. de Puzo, Jr., President P.O. Box 590
Eric S. Ende, Senior Vice President Ridgefield Park, New Jersey 07660
Christopher Linden, Senior Vice President (800) 279-1241 or (212) 613-7427
Robert L. Rodriguez, Senior Vice
President REGISTRAR
Steven R. Geist, Vice President ChaseMellon Shareholder Services, LLC
Janet M. Pitman, Vice President Ridgefield Park, New Jersey
Steven T. Romick, Vice President
William D. Jacobs, Treasurer STOCK EXCHANGE LISTING
Sherry Sasaki, Secretary New York Stock Exchange:
Christopher H. Thomas, Assistant Symbols: SOR Common Stock
Treasurer SOR+ Preferred Stock
INVESTMENT ADVISER
First Pacific Advisors, Inc.
11400 West Olympic Blvd., Suite 1200
Los Angeles, California 90064
</TABLE>
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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
After retreating in June and July, the bull market revived strongly in August
and September and by September 30 was up almost 14% year-to-date. This is the
equivalent of an 18% rate of advance for the entire year -- hardly what we would
have forecast following 1995's spectacular 37.5% gain.
During the most recent quarter, Source Capital's total net assets increased to
$377,446,549 from $376,166,604 at mid-year. Net asset value per Common Share
increased to $44.70 at September 30, 1996 from $44.53 at June 30, 1996. This
increase is after payment of a $0.925 cash distribution during the quarter.
INVESTMENT RESULTS
In the most recent quarter, Source Capital's net asset value per share of
Common Stock increased 2.5% while total net assets gained 2.5% with both
comparisons reflecting reinvestment of dividends and distributions paid during
the period. In comparison, the Standard & Poor's 500 Stock Average increased
3.1% during the quarter, also on a reinvested basis.
For the nine months ended September 30, 1996, the net asset value of Source
Capital Common Stock increased by 11.7% including reinvestment of distributions
paid during the period, while total net assets gained 11.0%. These increases
compare with a total positive return of 13.6% on the Standard & Poor's 500 Stock
Average.
NET INVESTMENT INCOME
Net investment income totalled $2,470,569 for the third quarter and $7,024,075
for the nine months, an increase of 4.2% and a decrease of 9.6%, respectively,
from the corresponding periods of 1995. After providing for Preferred dividends,
net investment income per Common Share amounted to $0.18 and $0.48 for the
quarter and nine months, respectively, compared with the $0.17 and $0.59 earned
in the corresponding periods of 1995.
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DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $0.925 per share was paid on
September 15, 1996 to shareholders of record on August 23, 1996. 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 $3.70
Common distribution rate is dependent upon achieving investment results which
will sustain a net asset value of approximately $37.00.
On November 4, 1996, the Board of Directors of Source Capital declared a
regular quarterly distribution at the rate of $0.925 per share and a special
year-end distribution of $2.43 per share, payable December 15, 1996, to
shareholders of record on November 22, 1996. The Internal Revenue Code requires
a regulated investment company to distribute substantially all of its net
investment income and net realized gains to shareholders of record on or before
December 31 in order to avoid the imposition of a federal excise tax. The
special year-end distribution of $2.43 per share was declared because the
Company has realized substantial capital gains during 1996. Capital gains are
the eventual result of successful investments. Changes in relative market
valuations as well as changing prospects of individual companies have led us to
sell certain holdings in 1996. We believe we have been able to replace these
securities both by adding to existing investments at advantageous prices and by
making selected new investments (primarily equity investments) offering
potentially better long-term investment returns.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on September 15,
1996 to shareholders of record on August 23, 1996. Asset coverage on the
Preferred shares was 697% on September 30, 1996, compared with 695% at June 30,
1996 and 669% at year-end 1995. Net investment income provided Preferred
dividend coverage of 209% in the third quarter and 198% for the nine months of
the current year, compared with 201% and 219%, respectively, in the
corresponding periods of 1995.
MARKET PRICE OF SOURCE CAPITAL SHARES
After decreasing from $41 7/8 to $41 in the first half of 1996, the market
price of Source Capital Common Stock increased to $42 1/8 at September 30, 1996.
This $1.125 increase in market price was more than the $0.17 gain in net asset
value during the quarter. As a result, the market discount from net asset value
decreased to 5.8% at September 30, 1996 from 7.9% at mid-year. The market price
of Source Capital Preferred Stock decreased from $28 3/8 to $28 1/4 during the
quarter.
COMMENTARY
I would like to review the philosophy which continues to guide the investment
of Source Capital's assets, and then discuss in detail several companies which
illustrate the fundamental and valuation characteristics we find attractive.
Our objective is to own better companies at lower valuations. This reflects
our belief that over the long term there is a high correlation between superior
business performance and high stock market returns. As shown in the following
table, the companies in Source's portfolio have grown faster, earn higher
returns, and are less leveraged than the average S&P Index company. Despite
these superior characteristics, Source's companies are currently priced at a
significantly lower PE ratio than the stock market.
<TABLE>
<CAPTION>
Source* S&P Index*
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<S> <C> <C>
EPS Growth Rate (10 Yr) 14% 9%
Return on Assets 12% 6%
Debt % Capital 25% 51%
PE Ratio 16x 20x
* Industrial companies only (i.e. excludes banks &
insurance)
</TABLE>
In addition to owning better companies, Source's portfolio is considerably
less volatile and less risky than the stock market as a whole. This is a
consequence of the kind of companies we invest in (high margins, leading market
shares, proven track record, low financial leverage), as well as our demanding
valuation criteria. We believe that this combination of superior companies,
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attractive valuations, and a low risk portfolio offers the Source Capital
shareholder a way to achieve good investment performance in strong markets,
while preserving capital in the uncertain markets which may lie ahead.
The three companies which we will discuss are typical of those in Source's
portfolio--a long record of superior performance, strong reason to believe that
such performance will continue, and reasonable valuation. The companies--Dover,
Kaydon, and Idex--are similar, even though there is little or no overlap in
their product line. Each is a manufacturer of capital goods, or capital goods
components, has an acquisition-based growth strategy, and of course a long
history of earning high returns on capital.
DOVER has been owned on and off by Source for the past fifteen years. Its
product line is the most diverse of the three companies. For many years its
leading division was U.S. Elevator, the #2 American elevator company (behind
Otis) and the leader in low-rise elevators. More recently, Dover's largest
operation has been Universal Instruments, a manufacturer of equipment for the
automated assembly of circuit boards. Other major operations, among Dover's more
than 40 divisions, include Imaje (inkjet printers for industrial applications),
Heil (garbage & dump trucks, and tank trailers), and Phoenix/Hill (commercial
refrigeration equipment).
Dover generates substantial free cash flow which it has spent mostly on
acquisitions though opportunistic share repurchase has also played a role.
During the past five years, Dover has spent $920 million on acquisitions and
$160 million on share repurchase, as well as paying out $280 million in
dividends. Net of increased debt, this is a total of $1 billion invested or paid
out to shareholders during the period, compared to beginning book value of about
$800 million -- an impressive rate of profitability. For its acquisitions, Dover
looks for businesses with leading market shares in well defined niche markets.
It will pay a fair price for businesses already earning excellent returns, with
strong management continuing in place.
KAYDON has been owned continuously by Source since first purchased in 1991. It
is primarily a manufacturer of bearings, rings, seals, filters, slip-rings, and
hydraulic cylinders. These products are incorporated into many different kinds
of capital equipment; for example, cranes, aircraft engines, and medical
scanners. Kaydon emphasizes highly engineered, customized products, produced at
low volumes over many years. It is typically the sole source for the components
it supplies.
Although Kaydon has made about a dozen acquisitions since it became a public
company in 1984, it has done so irregularly, often going a year or two without
making a significant purchase. Its acquisitions have been narrowly focused,
buying only businesses which, like Kaydon, manufacture low-volume, highly
engineered, difficult to fabricate metal industrial components. These companies
sometimes have to be "fixed," though they are all businesses capable of earning
at least close to the extraordinary 25% plus operating margins that Kaydon has
typically delivered. Over the past five years Kaydon has invested in
acquisitions or returned to shareholders a total of $180 million -- over 150% of
beginning shareholders' equity of $115 million.
It should be noted that Kaydon has been the target of asbestos related
litigation, although it has never produced or sold any asbestos product. The
lawsuit claims fraudulent conveyance of assets from Kaydon's former parent Keene
Corporation, which did have an asbestos business, at the time of Kaydon's
formation in 1983. Kaydon believes that the claims are invalid, as well as
barred by the statute of limitations. There is, however, a possibility of
unpleasant financial consequences for Kaydon, and this is reflected in its
current share price valuation.
IDEX, purchased by Source in 1996, is primarily a manufacturer of pumps,
owning eight different pump companies (75% of revenues), as well as several
manufacturers of industrial products. Its pumps typically have 30-50% market
shares of well-defined niche markets -- for example, fire truck mounted pumps
and metering pumps. Idex has invested aggressively in new product development
and believes it can grow at 7-9% even without acquisitions. It has, however,
kept up a rapid acquisition pace, most recently making its largest
purchase -- Fluid Management, a maker of pumps and related equipment used to mix
and dispense paints, coatings, inks, and dyes.
Although Idex was formed only in 1988, and went public in 1989, its operating
units are all decades old. Idex has made 10 acquisitions since 1989, and
continues to generate free cash at a high rate. It has spent a net $110 million
on acquisitions over the past three years, compared to just $60 million of
shareholders' equity at the start of this period. Idex targets manufacturers of
proprietary industrial products with significant engineering content and leading
positions in their niche markets. It wants to acquire sound companies and
improve them, not turn-arounds.
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<TABLE>
<CAPTION>
Dover Kaydon Idex S&P Index
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<S> <C> <C> <C> <C>
EPS Growth Rate (10 Yr) 17% 18% 22%(8 yrs) 9%
Operating Margin 13% 27% 18% 11%
Return on Equity 28% 27% 33% 20%
Operating Income/Assets 20% 34% 20% 11%
Debt % Capital 35% 4% 58% 51%
</TABLE>
As can be seen in the table above, each of these companies has been able to
grow rapidly through a combination of modest internal growth and intelligent use
of cash flow, directed mostly towards acquisitions. Many companies talk about
their "growth through acquisition" strategy, but far fewer can produce a
long-term track record which demonstrates that it has been done successfully.
In addition, these companies earn very high returns, whether measured on
sales, equity, or assets -- returns that are well above those earned by the
average S&P Index company. The figures shown are for 1996, but data for earlier
years would generally be comparable. These high returns are of course the source
of the free cash flow redeployed to increase earnings.
We would like to point out two other aspects of these figures. First, Idex
appears to have much higher leverage than the other two companies. This is
partly the result of accounting requirements related to its formation, and
partly because it is more leveraged. However, with high and stable margins, five
times interest coverage, and large cash flows, we are not overly concerned about
the debt level. Second, Kaydon clearly has higher returns than do the others,
especially considering its unleveraged balance sheet. In fact, Kaydon has net
cash equal to 20% of total assets. It has been "pickier" in doing deals, and as
a result has not been able to spend all its cash flow, and certainly not found
it necessary to go into debt. While we would prefer it if Kaydon were more
successful in finding appropriate companies to buy, it is better to have this
problem than the one of buying the wrong companies.
The next table presents some valuation measures for these companies. We find
Kaydon and Idex both relatively cheap, while Dover is more fully priced, in part
because of its longer record and its much larger size and better liquidity. Each
is considerably cheaper than the average S&P industrial company. All three
companies have some degree of economic risk. Earnings did decline in the last
recession, though not by very much, and could decline in the next one. However,
high rates of free cash flow will continue, and an adverse economic environment
could provide better than average acquisition opportunities (as well as for
share repurchase).
<TABLE>
<CAPTION>
Dover Kaydon Idex S&P Index
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<S> <C> <C> <C> <C>
Recent Price
(Nov. 7) 52 41 37 --
PE 18x 14x 15x 20x
Market Cap $6 billion $700 million $750 million $5 billion
Last Earnings
Decline (% decl.) 1991 (16%) 1991 (3%) 1991 (3%) 1991 (14%)
</TABLE>
We are also comforted by the high quality and stable management that each of
these companies has in place. At Dover, Tom Reese has been CEO for just two
years, but worked at Dover divisions for several decades before that. His
predecessor, Gary Roubos, was President or CEO for the prior seventeen years. At
Kaydon, Steve Clough was named CEO in 1996, having served as President since
1989. Chairman Larry Cawley became CEO in 1987. Idex's CEO, Don Boyce, has been
in charge since Idex was formed in 1988, and was with the predecessor firm,
Houdaille Industries, for the prior twenty years.
We believe that each of these three companies provides a potent combination of
experienced management executing proven strategies, high return businesses with
leading market shares, and below market valuations. They should provide
rewarding long-term returns to Source shareholders.
Respectfully submitted,
/s/ Eric S. Ende
Eric S. Ende
Senior Vice President
November 11, 1996
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MAJOR PORTFOLIO CHANGES
Quarter Ended September 30, 1996
<TABLE>
<CAPTION>
Shares or Ownership at
Principal Amount September 30, 1996
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<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Bandag, Incorporated .................... 20,000shs. 46,600shs.
Belden Inc. ............................. 51,500shs. 207,900shs.
Carnival Corporation (Class A)........... 21,700shs. 307,400shs.
Cooper Tire & Rubber Company ............ 68,000shs. 360,200shs.
Donaldson Company, Inc. ................. 34,600shs. 217,200shs.
Federal Signal Corporation .............. 95,200shs. 182,200shs.
IDEX Corporation ........................ 104,800shs. 275,900shs.
Kaydon Corporation ...................... 61,100shs. 213,400shs.
PREFERRED STOCK
Phoenix Duff & Phelps Corporation
(Series A)............................. 60,000shs. 75,000shs.
NON-CONVERTIBLE SECURITIES
Busse Broadcasting Corporation
--11 5/8% 2000......................... $ 350,000 $2,350,000
Trump Atlantic City Associates
--11 1/4% 2006......................... $4,000,000 $4,000,000
NET SALES
COMMON STOCKS
Bandag, Incorporated (Class A) .......... 20,000shs. 196,400shs.
Expeditors International of Washington,
Inc. .................................. 48,700shs. 183,100shs.
Farmers & Merchants Bank of Long
Beach ................................. 539shs. --0--
Hubbell Incorporated (Class B)........... 62,100shs. 85,264shs.
JP Realty, Inc. ......................... 153,000shs. --0--
Johnson & Johnson ....................... 50,800shs. 63,500shs.
Loctite Corporation ..................... 122,500shs. 56,700shs.
Marsh & McLennan Companies, Inc. ........ 40,400shs. 67,100shs.
Pfizer, Inc. ............................ 35,000shs. 64,500shs.
Reebok International Ltd. ............... 216,400shs. --0--
Washington Federal, Inc. ................ 231,219shs. --0--
CONVERTIBLE SECURITIES
California Energy Company, Inc.--5%
2000................................... $3,315,000 --0--
Quantum Health Resources, Inc.--
4 3/4% 2000............................ $2,305,000 --0--
</TABLE>
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COMPOSITION OF TOTAL NET ASSETS*
September 30, 1996
<TABLE>
<S> <C>
Investment securities (cost $273,438,463):
Common stocks............................................. $251,509,556
Convertible securities.................................... 23,919,733
Non-convertible securities................................ 47,494,912
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$322,924,201
Cash, receivables, short-term corporate notes, less
liabilities............................................... 54,522,348
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Total Net Assets at September 30, 1996...................... $377,446,549
===========
Assets applicable to Preferred Stock at a liquidation
preference of $27.50 per share (asset coverage 697%)...... $ 54,153,330
===========
Net Assets applicable to Common Stock -- $44.70 per share... $323,293,219
===========
</TABLE>
SUMMARY FINANCIAL INFORMATION*
<TABLE>
<CAPTION>
For the Periods Ended September 30, 1996
-----------------------------------------------
Nine Months Three Months
---------------------- ----------------------
Total Per Total Per
Net Common Net Common
Assets Share Assets Share
------------ ------- ------------ -------
<S> <C> <C> <C> <C>
Beginning of period.......... $362,086,804 $42.58 $376,166,604 $44.53
Net realized gain
on investments............. 39,466,280 5.46 10,204,865 1.41
Decrease in unrealized
appreciation of
investments................ (7,516,924) (1.04 ) (3,524,261) (0.49 )
Income available to
Common shareholders........ 3,479,494 0.48 1,289,042 0.18
Quarterly distribution to
Common shareholders..... (20,069,105) (2.78 ) (6,689,701) (0.93 )
------------ ------- ------------ -------
Net changes during period.... $ 15,359,745 $ 2.12 $ 1,279,945 $ 0.17
------------ ------- ------------ -------
End of period................ $377,446,549 $44.70 $377,446,549 $44.70
=========== ======== =========== ========
</TABLE>
<TABLE>
<CAPTION>
Dec. 31, 1995 June 30, 1996 Sept. 30, 1996
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<S> <C> <C> <C> <C>
Common market price per share........ 41 7/8 41 42 1/8
Common market discount from net asset
value.............................. 1.7% 7.9% 5.8%
Preferred asset coverage............. 669% 695% 697%
Preferred market price per share..... 28 1/2 28 3/8 28 1/4
* 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 BULK RATE
Los Angeles, California 90064 U.S. POSTAGE
PAID
CMSS
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