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[SOURCE CAPITAL LOGO]
SOURCE CAPITAL, INC.
FIRST QUARTER REPORT
March 31, 1996
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OFFICERS AND DIRECTORS
[SOURCE CAPITAL LOGO]
SOURCE CAPITAL, INC.
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DIRECTORS CUSTODIAN
Wesley E. Bellwood State Street Bank and Trust Company
Julio J. de Puzo, Jr. Boston, Massachusetts
David Rees COUNSEL
Robert L. Rodriguez O'Melveny & Myers
Lawrence J. Sheehan Los Angeles, California
Charles W. Stanton TRANSFER AND SHAREHOLDER
Kenneth L. Trefftzs SERVICE AGENT
OFFICERS Chemical Mellon Shareholder Services,
Julio J. de Puzo, Jr., President and L.L.C.
Treasurer P.O. Box 590
Eric S. Ende, Senior Vice President Ridgefield Park, NJ 07660
Christopher Linden, Senior Vice President (800) 279-1241 or (212) 613-7427
Robert L. Rodriguez, Senior Vice REGISTRAR
President Chemical Mellon Shareholder Services,
Janet M. Pitman, Vice President L.L.C.
Steven T. Romick, Vice President Ridgefield Park, New Jersey
Sherry Sasaki, Secretary STOCK EXCHANGE LISTING
Christopher H. Thomas, Assistant New York Stock Exchange:
Treasurer Symbols: SOR Common Stock
INVESTMENT ADVISER SOR+ Preferred Stock
First Pacific Advisors, Inc.
11400 West Olympic Blvd., Suite 1200
Los Angeles, California 90064
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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
As many of you may already know, George H. Michaelis, Source Capital's
long-time President and Chief Investment Officer was killed in a tragic accident
on March 10. The Directors and employees of both Source Capital and First
Pacific Advisors join Source's shareholders in mourning George's loss. He was an
exceptional investor and a respected colleague, friend, and mentor. George was a
truly outstanding human being who left an indelible mark on the Company, the
investment industry and all of us who had the privilege of working with him. His
lasting legacy is that he built an organization and team able to carry on in his
absence.
The Source Capital Board of Directors has elected Julio J. de Puzo, Jr., who
also serves as Treasurer, as President of Source Capital, and both Julio and
Robert L. Rodriguez as Directors. Julio has held various senior operating and
financial positions with the Company and its investment adviser during the past
17 years. Bob has served as a senior portfolio manager of the Company's
investment adviser for the past 13 years. I assumed principal responsibility for
the management of the portfolio on March 11, 1996, with the able assistance of
Steven Geist in equities, and Bob Rodriguez and Steven T. Romick in bonds. I
have been a close associate of George for the past 12 years, serving as a senior
research analyst and portfolio manager for the Company's investment adviser.
Working together, we will strive to continue the risk-averse, value-oriented
management style which George pioneered at Source Capital and pursued
successfully for so many years.
MARKET ENVIRONMENT
The first quarter's stock market saw an extension of the strong upward
momentum of 1995, with a gain of 5.5% in the S&P 500 Stock Index. Although the
market initially continued the narrowing leadership which characterized the
latter part of last year, by the end of the quarter the smaller stocks had
caught up and there was little difference in performance among the various
averages.
Early April saw a sharp increase in interest rates, as indications of a
stronger economy and higher inflation spooked the bond market. Stocks declined
in sympathy with bonds. While we feel that the probability is low for either
sharply higher inflation or an excessively strong economy, it is clear to us
that equity prices are relatively expensive compared to most past
periods -- high PE's, high price-to-book ratios, low yields. Such valuation
levels make a substantial stock market correction a real possibility, even in
the absence of meaningfully adverse economic events.
INVESTMENT RESULTS
Source Capital's total net assets increased to $371,791,461 from $362,086,804
at year-end. Net asset value per Common share increased to $43.92 at March 31,
1996 from $42.58 at year-end. In addition, a distribution of $0.925 was paid on
the Common shares during the quarter.
During this quarter, Source Capital's net asset value per share of Common
Stock increased 5.3% while total net assets gained 4.9%, with both figures
reflecting reinvestment of dividends and distributions paid during the period.
These changes compare with a 5.5% increase during the quarter for the Standard &
Poor's 500 Stock Index, also on a reinvested basis.
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NET INVESTMENT INCOME
Net investment income decreased during the quarter to $2,350,412 from
$2,625,601 in the first quarter of 1995. After providing for Preferred
dividends, net investment income per Common share amounted to $0.16 compared
with $0.20 in the prior year.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
In response to the continued growth in net asset value, the Board of Directors
has voted to increase the distribution rate on the Common Stock to an annualized
rate of $3.70. A regular quarterly distribution at the rate of $0.925 per share
was paid on March 15, 1996 to shareholders of record on February 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 total investment
results which will sustain a net asset value of approximately $37.00.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on March 15, 1996
to shareholders of record on February 23, 1996. The increase in the Company's
total net assets so far this year has led to an increase in the Preferred
shares' asset coverage from 669% at year-end 1995 to 687% at March 31, 1996. The
decline in net investment income in the first quarter decreased Preferred
dividend coverage to 199% compared to 222% in the first quarter of 1995.
MARKET PRICE OF SOURCE CAPITAL SHARES
The market price of Source Capital Common Stock increased during the quarter
from $41 7/8 at year-end 1995 to $42 1/8 at March 31, 1996. As this $0.25
increase in market price was less than the $1.34 gain in net asset value during
the period, the market discount to net asset value of 1.7% at year-end 1995
increased to 4.1% at March 31, 1996. The market price of Source Capital
Preferred Stock also increased during the quarter from $28 1/2 to $28 5/8
reflecting the steady decline in long-term interest rates during the period.
COMMENTARY
In our equity investments we will continue the approach that George followed
for many years -- looking for companies with a history of high returns on
capital, a strong market position with significant barriers to entry, a
relatively unleveraged balance sheet, and a proven ability to generate surplus
capital and use it wisely. Naturally, we also want to buy these businesses at
market or sub-market valuation levels.
Three holdings of Source Capital, each added to the portfolio in 1995,
illustrate the kinds of securities that have attracted us in the past, and will
continue to do so in the future: Carnival, Lancaster Colony, and Caraustar
Industries. Carnival is the largest company in the cruise industry, operating
the well-known Carnival Cruise Lines and Holland America Line. It has been
adding 1-2 new ships to its fleet annually, increasing market share and
enhancing its competitive position because of the consumer's preference for new
vessels. Carnival outspends its competitors in advertising and has the largest
sales force calling on travel agents. Many of Carnival's competitors are in dire
financial straits, and are being bought by the stronger cruise companies, or
simply shutting down. At $300+ million per ship, this is not an easy business to
stay in or to enter. Carnival has the industry's strongest balance sheet and
sufficient cash flow to
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fund its rapid growth. Its operating margin (23%) and return on equity (23%)
lead the industry. Despite its strong competitive position and high returns,
Carnival sells at only a modest PE -- 16x trailing 12 months, and less than 14x
projected 1996 earnings.
Lancaster Colony manufactures consumer products, including specialty foods,
automotive accessories, candles and glassware. In food products, Lancaster
offers a wide assortment of dips, dressings and sauces that are typically sold
regionally to both retail and foodservice customers. Lancaster grows its food
business both by acquisition and by expanding the distribution of existing
products. The automotive sector includes floor mats and light truck accessories,
sold to both original equipment manufacturers (OEMs) and aftermarket
distributors. The stable aftermarket and growing light truck segment balance the
more cyclical auto OEM business. Lancaster is the leading supplier of candles
and glass candle holders to mass merchandisers, a channel of distribution which
has been gaining share from the more traditional card shops and department
stores, and is the only company to internally source both products. Lancaster's
return on equity has averaged 22% for the past eight years, earnings have
compounded at 20% for a decade, and debt-to-total capitalization ratio is a
modest 14%. The current valuation is 14x trailing 12 months, and about 12x
projected 1996 earnings.
Caraustar Industries is one of the leading companies producing paperboard
(cardboard) from recycled fiber. In the traditional paper industry, which uses
pulp from trees as the primary raw material, high fixed costs encourage
producers to maximize capacity utilization almost regardless of price level,
leading to margins and profits which vary from very good at cyclical peaks to
abysmal at other times. In contrast, producers using recycled fiber have high
variable, but low fixed costs, leading to more rational behavior. This has
produced quite stable operating margins for the industry over the economic
cycle. In addition to benefiting from the industry's attractive economic
characteristics, Caraustar is a remarkably low cost producer, having productive
mills and raw material costs under those of its competitors. As a result,
Caraustar has been able to earn outstanding returns, with operating margins
approaching 15% and returns on equity of 40%. Although it was relatively
leveraged at the time of its initial public offering in 1992, Caraustar has made
substantial progress in improving its balance sheet since that time, and debt is
now about 40% of total capital, with interest expense covered better than ten
times by operating income. Caraustar has invested its large cash flow into
acquisitions of paperboard mills and conversion facilities -- made readily
available by the fragmented structure of its industry. Because of its relatively
short time as a public company and its association with commodity paper
producers, Caraustar continues to sell at what we believe is an excessively
cheap price -- currently about 12x expected 1996 earnings.
The three companies I have discussed are representative of the others in
Source's portfolio -- understandable businesses, high returns, reasonable
valuations. I expect that ownership of these companies, and others like them in
the George Michaelis tradition, will continue to provide excellent returns to
Source shareholders, without assuming excess risk.
Respectfully submitted,
[SIG LOGO]
Eric S. Ende
Senior Vice President
April 16, 1996
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MAJOR PORTFOLIO CHANGES
Quarter Ended March 31, 1996
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<CAPTION>
Shares or Ownership at
Principal Amount March 31, 1996
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NET PURCHASES
Common Stocks
Arbor Drugs, Inc. ......................... 57,800 shs. 266,600 shs.
Arrow Electronics, Inc..................... 42,600 shs. 134,700 shs.
DENTSPLY International Inc. ............... 39,200 shs. 146,300 shs.
Dover Corporation.......................... 8,500 shs. 156,400 shs.
First Interstate Bancorp................... 34,900 shs. 34,900 shs.
JP Realty, Inc. ........................... 15,000 shs. 168,800 shs.
Leggett & Platt, Incorporated.............. 40,200 shs. 194,100 shs.
Manpower Inc. ............................. 30,600 shs. 233,700 shs.
Norwest Corporation........................ 25,200 shs. 162,088 shs.
Premark International, Inc. ............... 111,300 shs. 111,300 shs.
Reebok International Ltd. ................. 18,400 shs. 216,400 shs.
Unifi, Inc. ............................... 96,400 shs. 283,500 shs.
Convertible Security
TriMas Corporation -- 5% 2003.............. $ 890,000 $ 2,550,000
Non-Convertible Security
Government National Mortgage Association
-- 7.99% 2010............................ $ 635,200 $ 2,955,600
NET SALES
Common Stocks
Armor All Products Corporation............. 98,700 shs. --0--
Cedar Fair, L.P. .......................... 145,000 shs. 54,200 shs.
Farmers & Merchants Bank of Long Beach..... 800 shs. 839 shs.
First National Bank of Anchorage, The...... 950 shs. 4,390 shs.
Gap, Inc., The............................. 67,700 shs. --0--
Grainger (W.W.), Inc. ..................... 61,400 shs. --0--
Hasbro, Inc. .............................. 179,400 shs. --0--
Johnson & Johnson.......................... 14,900 shs. 94,200 shs.
Kelly Services, Inc. (Class A)............. 146,400 shs. --0--
Lubrizol Corporation, The.................. 35,700 shs. 196,000 shs.
McDonald's Corporation..................... 99,400 shs. --0--
Wachovia Corporation....................... 74,400 shs. --0--
Watts Industries, Inc. (Class A)........... 134,800 shs. --0--
Washington Federal, Inc. .................. 47,500 shs. 289,019 shs.
Convertible Securities
Diagnostic/Retrieval Systems, Inc.
-- 8 1/2% 1998........................... $ 714,000 $ 719,000
Johnson Electric Holdings Limited
-- 4 1/2% 2000........................... $ 4,500,000 --0--
Non-Convertible Securities
Federal National Mortgage Association
-- 9.15% 1999 (Indexed Notes)............ $ 295,300 --0--
United International Holdings, Inc. -- 0%
1999..................................... $ 6,245,000 --0--
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COMPOSITION OF TOTAL NET ASSETS*
March 31, 1996
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Investment securities (cost $269,941,508):
Common stocks............................................. $253,163,900
Convertible bonds and debentures.......................... 35,362,778
Non-convertible bonds and debentures...................... 44,108,968
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$332,635,646
Cash, receivables, short-term corporate notes, less
liabilities............................................... 39,155,815
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Total Net Assets at March 31, 1996.......................... $371,791,461
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Assets applicable to Preferred Stock at a liquidation
preference of $27.50 per share (asset coverage 687%)...... $ 54,153,330
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Net Assets applicable to Common Stock -- $43.92 per share... $317,638,131
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SUMMARY FINANCIAL INFORMATION*
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Three Months Ended
March 31, 1996
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Total Per
Net Common
Assets Share
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Beginning of period............................ $362,086,804 $42.58
Net realized gain on investments............... 9,533,997 1.32
Increase in unrealized appreciation of
investments.................................. 5,691,477 0.79
Income available to Common shareholders........ 1,168,885 0.16
Quarterly distribution to Common
shareholders................................. (6,689,702) (0.93)
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Net changes during period...................... $ 9,704,657 $ 1.34
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End of period.................................. $371,791,461 $43.92
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Beginning End
of Quarter of Quarter
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Common market price per share.................. 41 7/8 42 1/8
Common market discount from net asset value.... 1.7% 4.1%
Preferred asset coverage....................... 669% 687%
Preferred market price per share............... 28 1/2 28 5/8
* 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.
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SOURCE CAPITAL, INC. BULK RATE
11400 West Olympic Boulevard, Suite 1200 U.S. POSTAGE
Los Angeles, California 90064 PAID
CMSS
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