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[LOGO]
SOURCE CAPITAL, INC.
FIRST QUARTER REPORT
March 31, 1997
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OFFICERS AND DIRECTORS
[LOGO]
SOURCE CAPITAL, INC.
DIRECTORS
Wesley E. Bellwood
Julio J. de Puzo, Jr.
David Rees
Robert L. Rodriguez
Lawrence J. Sheehan
Charles W. Stanton
Kenneth L. Trefftzs
OFFICERS
Julio J. de Puzo, Jr., PRESIDENT
Eric S. Ende, SENIOR VICE PRESIDENT AND CHIEF
INVESTMENT OFFICER
Robert L. Rodriguez, SENIOR VICE PRESIDENT
Steven R. Geist, VICE PRESIDENT
Janet M. Pitman, VICE PRESIDENT
Steven T. Romick, VICE PRESIDENT
J. Richard Atwood, TREASURER
Sherry Sasaki, SECRETARY
Christopher H. Thomas, ASSISTANT TREASURER
INVESTMENT ADVISER
First Pacific Advisors, Inc.
11400 West Olympic Blvd., Suite 1200
Los Angeles, California 90064
CUSTODIAN
State Street Bank and Trust Company
Boston, Massachusetts
COUNSEL
O'Melveny & Myers LLP
Los Angeles, California
TRANSFER AND SHAREHOLDER SERVICE AGENT
ChaseMellon Shareholder Services, L.L.C.
85 Challenger Road
Overpeck Centre
Ridgefield Park, NJ 07660
(800) 279-1241 or (212) 613-7427
REGISTRAR
ChaseMellon Shareholder Services, L.L.C.
Ridgefield Park, New Jersey
STOCK EXCHANGE LISTING
New York Stock Exchange:
Symbols: SOR Common Stock
SOR+ Preferred Stock
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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
INVESTMENT RESULTS
Source Capital's total net assets decreased to $375,667,984 from $382,146,427
at year-end. Net asset value per Common share decreased to $44.01 at March 31,
1997 from $45.35 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
decreased 1.0% while total net assets declined 0.5%, with both figures
reflecting reinvestment of dividends and distributions paid during the period.
These changes compare with a 2.6% increase during the quarter for the Standard &
Poor's 500 Stock Index, also on a reinvested basis.
These changes compare to a 3.4% decline in the Russell 2500 Index, also on a
reinvestment basis. The reader may recall our discussion in the Source 1996
Annual Report about the most appropriate benchmark for the performance of the
Company, in which we concluded the greater similarities in market cap and
portfolio weighting between Source and the Russell 2500 made that index a much
better guide than the S&P 500.
NET INVESTMENT INCOME
Net investment income decreased during the quarter to $1,976,386 from
$2,350,412 in the first quarter of 1996. After providing for Preferred
dividends, net investment income per Common share amounted to $0.11 compared
with $0.16 in the prior year.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $0.925 per share was paid on
March 15, 1997 to shareholders of record on February 21, 1997. 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, 1997 to
shareholders of record on February 21, 1997. The decrease in the Company's total
net assets so far this year has led to a decrease in the Preferred shares' asset
coverage from 706% at year-end 1996 to 694% at March 31, 1997. The decline in
net investment income in the first quarter decreased Preferred dividend coverage
to 167% compared to 199% in the first quarter of 1996.
MARKET PRICE OF SOURCE CAPITAL SHARES
The market price of Source Capital Common Stock decreased during the quarter
from $45 1/2 at year-end 1996 to $44 1/4 at March 31, 1997. As this $1.25
decrease in market price was less than the $1.34 decline in net asset value
during the period, the market premium to net
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asset value of 0.3% at year-end 1996 increased to 0.5% at March 31, 1997. The
market price of Source Capital Preferred Stock also decreased during the quarter
from $28 5/8 to $28 1/2.
COMMENTARY
The First Quarter of 1997 was a difficult one for many investors, as the
narrowness of the stock market advance, so evident in 1996's results, continued
into the new year. For example, the 100 largest stocks in the S&P 500 Index were
up over 3% in the quarter, while the Russell 2000 Index, which tracks much
smaller companies, was down more than 5%, a performance differential of 8 1/2%.
Since the beginning of 1996, the biggest S&P stocks are up 34%, while the
Russell 2000 is ahead only 10%, an astounding difference. Under the
circumstances, we consider Source's 1% first quarter decline and almost 21% gain
since the start of 1996 to be quite respectable performance, particularly given
the relative absence of really large companies from the portfolio.
The market environment has also been unforgiving for many companies. Even
modest disappointments in business performance have led to significant declines
in stock prices. We expect that Source's portfolio of superior companies
operating in relatively unvolatile businesses, and held at below-market
valuations, will continue to shield our shareholders, even if the market
environment remains hazardous.
A new name in the portfolio this quarter is NUCOR, a manufacturer of steel and
steel products. It is unusual for Source to own producers of commodity products
like metals, paper, or basic chemicals -- whose physical characteristics are
nearly identical and where competition is based largely on price. Historically,
such businesses have not enjoyed the superior returns on capital which we
require as a prerequisite to ownership. There are exceptions, however, and Nucor
is one of them.
The key to earning superior returns in a commodity business is having a low
cost structure. Nucor's low costs are based on the ability to construct plants
at a capital cost below that of competitors, on the use of advanced technology
to simplify and automate the production process, and on the high productivity
with which their non-union labor force operates.
The difference between Nucor and the large, integrated steel companies is
dramatic. Although Nucor factory workers earn salaries which are comparable to
or greater than those of union workers (for Nucor, $55,000 for an unskilled
worker, $85,000 for higher skill levels), the pay is based on meeting high
productivity targets, not on union contracts. As a result, Nucor produces steel
using less than one man-hour per ton, while the average U.S. integrated steel
producer requires four hours.
Cost advantages like these permit Nucor to earn much higher rates of return
than its U.S. competitors. Over the past 10 years Nucor has averaged 15% return
on equity, with only modest leverage, even though, for part of this period, the
industry was under severe stress. During 1990-1993, four large integrated steel
producers (U.S. Steel, Inland, Bethlehem, and AK) lost $6.3 billion, with each
company losing money virtually every year. In contrast, Nucor earned $350
million during this period, with trough profitability of 10% on equity.
Ten years ago Nucor was primarily a traditional mini-mill, producing about
1 1/2 million tons a year. Although efficient and low cost, mini-mills have
traditionally made products, such as rebar, for which close control of
metallurgy and surface quality was not necessary. During the past decade Nucor
has invaded the province of the integrated mills, using innovative new
technology to significantly broaden its product offering, as well as greatly
increase production.
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It entered the market for hot and cold rolled sheet steel, completing a plant
near Crawfordsville, Indiana in 1989. It introduced a production process
involving the continuous casting of a thin slab, saving time, energy, and labor
compared to prior methods. It has subsequently built two more sheet mills and
its 1997 sheet production should be about 5 million tons, or close to 10% of
U.S. output. In 1988 it started operation of a new mill in Hickman, Arkansas to
produce wide-flange beams in a joint venture with Yamato Kogyo. The mill uses a
continuous casting method which produces a beam blank closer in shape to that of
the finished beam than traditional methods. The leading U.S. beam producer at
that time, Bethlehem Steel, has recently left the business, leaving Nucor with
the leading market share. Nucor expanded beam capacity in 1993 and recently
announced that it would construct a second beam mill, increasing capacity to 2.5
million tons.
We believe that the competitive advantages which enabled Nucor to increase
steel production five fold over the past ten years, funded entirely from
internal cash flow, are still in place. We expect to see continued profitable
investment opportunities and sales and income growth. At its recent price of
$48, Nucor's stock is at the same level as early 1993 and well below its 1994
high of $72. Earnings estimates for 1997 average about $3.50 per share, although
with an unusually wide range, giving Nucor a PE of less than 14x. We find this
valuation attractive and hope to find opportunities to further increase our
position.
We will continue to search for companies such as Nucor -- which combine high
returns on capital, excellent growth prospects, strong balance sheets, and
reasonable valuations. We believe that Source's portfolio of superior businesses
like this one should provide shareholders with rewarding long-term returns,
without assuming excess risk.
Respectfully submitted,
[/S/ ERIC S. ENDE]
Eric S. Ende
Senior Vice President and
Chief Investment Officer
May 13, 1997
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MAJOR PORTFOLIO CHANGES
Quarter Ended March 31, 1997
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<CAPTION>
Shares or Ownership at
Principal Amount March 31, 1997
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<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Bandag, Incorporated........................................ 40,500shs. 243,000shs.
Caraustar Industries, Inc................................... 104,800shs. 437,500shs.
Methode Electronics, Inc. (Class A)......................... 386,200shs. 386,200shs.
Nucor Corporation........................................... 87,500shs. 87,500shs.
Poe & Brown, Inc............................................ 44,700shs. 173,400shs.
Toys "R" Us, Inc............................................ 188,200shs. 188,200shs.
TriMas Corporation.......................................... 183,010shs. 272,810shs.
Tupperware Corporation...................................... 59,000shs. 275,000shs.
CONVERTIBLE SECURITIES
Excel Realty Trust, Inc. Preferred (Series A)............... 200,000shs. 200,000shs.
NovaCare, Inc. -- 5 1/2% 2000............................... $ 3,000,000 $ 3,000,000
NET SALES
COMMON STOCKS
Bandag, Incorporated (Class A).............................. 40,500shs. --0--
Expeditors International of Washington, Inc................. 85,700shs. 226,500shs.
Genuine Parts Company....................................... 27,600shs. 72,400shs.
Horace Mann Educators Corporation........................... 37,200shs. 137,000shs.
Hubbell Incorporated (Class B).............................. 50,264shs. --0--
Johnson & Johnson........................................... 63,500shs. --0--
Lancaster Colony Corporation................................ 22,500shs. 262,000shs.
Marsh & McLennan Companies, Inc............................. 28,600shs. --0--
Norwest Corporation......................................... 17,900shs. 104,688shs.
Pfizer Inc.................................................. 55,400shs. --0--
Unifi, Inc.................................................. 44,800shs. 238,700shs.
Wells Fargo & Company....................................... 2,900shs. 20,366shs.
CONVERTIBLE SECURITIES
Healthsource Inc. -- 5% 2003................................ $ 2,500,000 $ 2,500,000
Rockefeller Center Properties, Inc. -- 0% 2000.............. $ 1,450,000 $ 3,005,000
TriMas Corporation -- 5% 2003............................... $ 2,550,000 --0--
NON-CONVERTIBLE SECURITY
Tenet Healthcare Corporation -- 9 5/8% 2002................. $ 2,800,000 --0--
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COMPOSITION OF TOTAL NET ASSETS*
March 31, 1997
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<S> <C>
Investment securities (cost $302,607,736):
Common stocks............................................ $279,877,320
Convertible bonds, debentures and preferred stocks....... 31,157,972
Non-convertible bonds and debentures..................... 43,506,505
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$354,541,797
Cash, receivables, short-term corporate notes, less
liabilities.............................................. 21,126,187
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Total Net Assets at March 31, 1997......................... $375,667,984
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Assets applicable to Preferred Stock at a liquidation
preference
of $27.50 per share (asset coverage 694%)................ $54,153,330
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Net Assets applicable to Common Stock -- $44.01 per
share.................................................... $321,514,654
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SUMMARY FINANCIAL INFORMATION*
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<CAPTION>
Three Months Ended March 31,
1997
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Total Per
Net Common
Assets Share
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<S> <C> <C>
Beginning of period.................................................... $ 382,146,427 $ 45.35
Net realized gain on investments....................................... 15,870,033 2.18
Decrease in unrealized appreciation of investments..................... (19,761,396) (2.70)
Income available to Common shareholders................................ 794,859 0.11
Quarterly distribution to Common shareholders.......................... (6,745,683) (0.93)
Proceeds from shares issued for distributions reinvested............... 3,363,744 --
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Net changes during period.............................................. $ (6,478,443) $ (1.34)
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End of period.......................................................... $ 375,667,984 $ 44.01
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<CAPTION>
Beginning End
of Quarter of Quarter
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<S> <C> <C>
Common market price per share.......................................... 45 1/2 44 1/4
Common market premium to net asset value............................... 0.3% 0.5%
Preferred asset coverage............................................... 706% 694%
Preferred market price per share....................................... 28 5/8 28 1/2
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* 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.
11400 West Olympic Boulevard,
Suite 1200
Los Angeles, California 90064
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U.S. POSTAGE
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