<PAGE>
[LOGO]
SOURCE CAPITAL, INC.
SEMI-ANNUAL REPORT
for the six months ended June 30, 1998
<PAGE>
SOURCE CAPITAL, INC.
[LOGO]
DIRECTORS
Willard H. Altman
Wesley E. Bellwood
Julio J. de Puzo, Jr.
David Rees
Robert L. Rodriguez
Lawrence J. Sheehan
Charles W. Stanton
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 (201) 329-8660
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
<PAGE>
SUMMARY FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Six months ended Year ended
June 30, 1998 December 31, 1997
--------------------------- ---------------------------
Total Total
Net Per Common Net Per Common
Assets Share Assets Share
-------------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
Beginning of period.................................................... $ 425,490,107 $ 50.20 $ 382,146,427 $ 45.35
Net gain on investments, realized and unrealized....................... 28,228,142 3.81 76,662,465 10.50
Income available to Common shareholders................................ 1,352,335 0.18 3,232,410 0.43
Regular distributions to Common shareholders........................... (15,193,506) (2.05) (44,409,618) (6.08)
Proceeds from shares issued for distributions reinvested
by shareholders...................................................... 3,033,687 -- 7,858,423 --
-------------- ----------- -------------- -----------
Net changes during period.......................................... $ 17,420,658 $ 1.94 $ 43,343,680 $ 4.85
-------------- ----------- -------------- -----------
End of period.......................................................... $ 442,910,765 $ 52.14 $ 425,490,107 $ 50.20
-------------- ----------- -------------- -----------
-------------- ----------- -------------- -----------
</TABLE>
<TABLE>
<CAPTION>
June 30, 1998 December 31, 1997 December 31, 1996
------------- ----------------- -----------------
<S> <C> <C> <C>
Common market price per share........................................... 53 3/8 51 1/16 45 1/2
Common market premium to net asset value................................ 2.4% 1.7% 0.3%
Preferred asset coverage................................................ 818% 786% 706%
Preferred liquidation preference per share.............................. $27.50 $27.50 $27.50
Preferred market price per share........................................ 30 29 28 5/8
</TABLE>
- --------------------------------------------------------------------------------
DESCRIPTION OF THE COMPANY
SOURCE CAPITAL, INC. is a major diversified, publicly traded investment
company with total net assets of approximately $443,000,000. Its investment
portfolio includes a wide range of securities with primary emphasis on common
stocks and convertible debentures.
Source Capital has Common and Preferred shares outstanding, both of which are
traded on The New York Stock Exchange. The 1,969,212 outstanding Preferred
shares each have a prior claim of $27.50 on assets and $2.40 per year on income.
The balance of the Company's assets and income are available to the 7,455,649
shares of Common Stock.
Source Capital's investment objective is to seek maximum total return for
Common shareholders from both capital appreciation and investment income to the
extent consistent with protection of invested capital and provision of
sufficient income to meet the dividend requirements of Preferred shareholders.
Source Capital is not a mutual fund. Thus, it does not repurchase its own
shares on demand and does not need to structure its portfolio securities to
provide for possible redemptions. As a publicly traded investment company,
Source Capital's Common and Preferred shares are bought and sold on The New York
Stock Exchange, and the Company is not involved in the transaction.
Source Capital's investment approach emphasizes primarily equity and
equity-related investments in seeking to achieve its growth objective for its
Common shareholders. The desirability of equity versus fixed-income investments
has been increasingly debated in recent years. Source Capital's position is that
without assuming undue risk and recognizing the fixed claim of its Preferred
Stock, properly selected stocks offer the better long-term opportunity for
overall investment return as well as long-term protection from the large but
uncertain threat of inflation. Source Capital's equity investments have been
directed toward companies with highly liquid, relatively unleveraged balance
sheets and a demonstrated long-term ability to earn above average returns on
invested capital. Source Capital's equity investment portfolio is based on
fundamental judgments of long-term returns attainable from income and
appreciation in the securities of such companies and is not derived from overall
economic forecasts or stock market predictions.
Source Capital has a Common Stock Distribution Policy which provides for cash
distributions of approximately 10% of the ongoing net asset value of its Common
shares. Only a portion of such distributions is paid from net investment income.
The remainder is paid from any net realized capital gains and/or paid-in
capital, as determined by each year's results. To the extent the Company
realizes net long-term capital gains for any year in excess of the amounts
distributed under the Company's distribution policy, such excess may be
distributed to shareholders or retained by the Company. Distributions to Common
shareholders are paid quarterly in a fixed amount which is periodically adjusted
after sustained changes in net asset value appear to the Board of Directors
reasonably likely to support the new distribution rate on a continuing basis.
This policy is designed to allow Common shareholders to benefit not only from
income, but a portion of the capital appreciation which has resulted to date.
All distributions are taxable to shareholders as dividend income or capital gain
distributions since the Company has accumulated earnings and profits from prior
years.
Since the policy was adopted in June 1976, at an initial annual rate of $1.40
per share, continued increases in net asset value, despite payments from
capital, have permitted 18 subsequent increases to the current rate of $4.20.
Maintenance of the current $4.20 annualized rate is dependent upon achieving a
total return on the Common Stock from both income and appreciation to sustain a
net asset value of approximately $42.00.
1
<PAGE>
LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
Source Capital's total net assets decreased from $453,756,612 to $442,910,765
during the second quarter. Net asset value per Common share amounted to $52.14
at June 30, 1998 compared with $53.82 at March 31, 1998 and $50.20 at year-end
1997. These changes in net asset value were net of cash distributions of $1.00
paid in the first quarter and $1.05 paid in the second quarter.
INVESTMENT RESULTS, 1998 FIRST HALF
For the six months ended June 30, 1998 the net asset value per share of Source
Capital's Common Stock increased by 8.0%, including distributions paid during
the period, while total net assets gained 7.5%. These returns compare with a
5.7% increase in the Russell 2500 Index. The foregoing changes were calculated
on the basis of reinvesting all dividends and distributions.
INVESTMENT RESULTS, 1998 SECOND QUARTER
In the most recent quarter, Source Capital's net asset value per share of
Common Stock decreased 1.2%, including the $1.05 distribution paid during the
period, while total net assets declined 0.8%, both on a reinvestment basis. In
comparison, the Russell 2500 Index decreased 4.2% during the quarter, also on a
reinvestment basis.
NET INVESTMENT INCOME
Net investment income amounted to $1,707,018 and $3,715,389 for the second
quarter and six months, respectively, as against $1,967,579 and $3,943,965 in
the comparable periods of 1997. After providing for Preferred dividends, net
investment income per Common share was $0.07 and $0.18 for the quarter and
six-month periods, respectively, compared to the $0.11 and $0.22 earned in the
corresponding periods of 1997.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution of $1.05 per share was paid on June 15, 1998
to shareholders of record on May 29, 1998. This payment marks the 21st
anniversary of Source Capital's 10% Distribution Policy which calls for total
annual payments approximating 10% of the Common Stock's ongoing net asset value.
Since the adoption of this policy, continuing growth in net asset value has led
to 18 increases in the distribution rate totaling 200%--from the original $1.40
rate in June 1976, to the current $4.20 rate. The growth in the net asset value
which has permitted this continuing expansion in cash distributions has been
achieved despite distributions in excess of net investment income of
$326,023,258 or $49.94 per Common share, and payments of federal income tax on
undistributed realized capital gains amounting to $36,198,677 or $5.99 per
Common share. Maintenance of the current $4.20 rate is dependent upon achieving
long-term investment results which sustain a net asset value of approximately
$42.00.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on June 15, 1998,
to shareholders of record on May 29, 1998. The changes in the Company's total
net assets since year-end 1997 have resulted in changes in the Preferred shares'
asset coverage from 786% at December 31, 1997 to 838% at March 31, 1998, and
818% at June 30, 1998. The decrease in net investment income led to a decline in
Preferred dividend coverage to 144% for the second quarter and 157% for the six
months, compared to 167% in each of the corresponding periods of 1997.
MARKET PRICE OF SOURCE CAPITAL SHARES
The market price of Source Capital Common Stock increased from $51 1/16 to
$53 3/8 during the first half of 1998. As this $2.31 increase in market price
was greater than the $1.94 gain in the underlying net asset value, the market
premium to net asset value of 1.7% at year-end 1997 increased to 2.4% at June
30, 1998. The market price of Source Capital Preferred Stock increased to $30 at
June 30, 1998 from $29 at year-end 1997.
COMMENTARY
For yet another quarter, large capitalization companies rose in price, with
the S&P 500 gaining 3%, and the biggest of the big doing even better--the fifty
largest S&P companies were up 7%. Unfortunately, the average company did not
share in these happy times; the Russell 2500 was down 4% for the quarter. Within
this context, the 1.2% decline in Source Capital's net asset value per share
represents a respectable, if regrettably negative, performance.
Turning our attention to the first half of 1998, the powerful market gains
which began in 1995 continued unabated, with the biggest-cap stocks continuing
to take a disproportionate share. The following table shows just how dramatic
this disparity was.
<TABLE>
<CAPTION>
January - June 1998
Market Cap Range Performance
- ---------------------------------- ---------------------
<S> <C>
Over $20 Billion +16.6%
5 - 20 Billion 9.0%
2 - 5 Billion 3.6%
250 Million - 2 Billion 1.1%
Under $250 Million (2.0)%
</TABLE>
Source: Salomon Smith Barney
With most of the companies in Source Capital's portfolio in the mid-cap and
small-cap range of $250 million to $5 billion, the first half gain of 8% in net
asset value per share is quite respectable.
We should take this opportunity to emphasize that Source Capital's stock
selection process is not market-cap driven. Rather we seek out high return,
relatively unleveraged businesses which can be purchased at reasonable
valuations and held for long periods. For a number of years, this approach has
identified mostly mid- and small-cap stocks, and only a few larger-cap names.
Most of the bigger companies, in our opinion, are too expensive, and offer
little opportunity for us to add value by identifying mispriced or misunderstood
companies.
Source Capital's portfolio continues to meet our objective of owning better
companies selling at lower valuations. As shown on the table below, these
companies have grown faster, earned higher returns, and possess superior balance
sheets, yet are priced at lower PE ratios than the average Russell 2500 Index
company.
<TABLE>
<CAPTION>
Source Russell 2500
Capital Index
------------- -----------------
<S> <C> <C>
EPS Growth (10 year) 17% 9%
Return on Assets 10% 6%
Debt % of Capital 28% 47%
PE Ratio (last 12 months) 19x 26x
</TABLE>
In this shareholder report, I would like to discuss two companies which we
have purchased over the past few months. Although they are in different
businesses--one sells computer networking products and the other metal working
consumables and related products--there are surprising similarities in their
operations. Each is a catalog distributor
2
<PAGE>
to mostly smaller companies, offering high service levels, an extensive product
selection, and valuable technical knowledge.
These companies also have very attractive financial characteristics. In
addition to the high returns on capital, unleveraged balance sheets, and
below-market valuations that we always look for, each company has significant
future growth opportunities in its existing businesses.
BLACK BOX is a direct marketer via catalog of computer communications,
networking and connectivity equipment. Its catalog includes over 7,000 items,
many of them hard to find, and mostly carrying the Black Box private label. It
ships orders the same day they are received, with a 95% fulfillment rate.
The key element of Black Box's business, which distinguishes it from other
marketers of similar products, is its unparalleled levels of technical support.
Black Box provides free 24-hour, 7-day access to highly skilled computer
professionals whose job is to solve customers' problems (often with the aid of
Black Box products). What's more this help is fast. The typical industry
response to service calls is to start the customer with 10 minutes on hold.
Black Box answers the phone in 20 seconds.
Black Box has steadily grown sales at a 15-20% rate, while maintaining low-20s
operating margins and earning high returns on capital. We believe this happy
combination is sustainable into the future.
We established our position in Black Box during the second quarter, buying
stock in the low 30s. Earnings in 1998 are expected to be about $2.00 per share,
which we feel gives this high quality and dynamic business an attractive
valuation.
JLK DIRECT DISTRIBUTION is a leading distributor of a broad range of metal
cutting consumables and related products, including cutting tools, abrasives,
measuring instruments, hand tools, and general workshop supplies. The company
had its initial public offering just a year ago, as a partial spin-out from
Kennametal, which still owns 80%. Kennametal is the second largest world-wide
producer of cutting tools.
JLK operates two somewhat related, but distinct businesses, J&L Industrial
Supply and Full Service Supply. Of the two, J&L is the more exciting and
important.
J&L Industrial Supply is a direct marketer of metal cutting products to small
and medium size businesses. Kennametal purchased it about 10 years ago to give
it access to customers which it could not economically reach with its own direct
sales force. It has been able to grow rapidly and profitably because of the
significant competitive advantages it has over its mostly small and sleepy
competitors. J&L offers superior selection--a 110,000-product catalog, with
good-better-best alternatives. It provides rapid fulfillment, shipping 99% of
domestic orders on the day received for overnight or second day delivery.
Customers with more urgent requirements can pick-up their order at J&L showrooms
located in 25 major U.S. markets. As the exclusive distributor of Kennametal
product to smaller businesses, J&L can offer a premier brand, giving it instant
credibility with potential customers. Finally, J&L is a source of technical
metal cutting knowledge, both from its telemarketing staff, and from sales reps
based in major market showrooms.
Full Service Supply serves large manufacturers, like General Motors, Deere,
Rockwell, and Pratt & Whitney, by letting them outsource the entire process of
acquiring and inventorying metal working and related products at manufacturing
facilities. Full Service Supply's logistics expertise, purchasing power, and
technical knowledge can realize significant customer savings. This has resulted
in rapid growth of this business, and Full Service Supply now services about 50
customers at over 100 site locations.
We have been attracted by JLK Direct since before it became a public company.
We purchased shares of Kennametal in early 1997, more interested in its
distribution operations than in its core manufacturing business. At the time of
JLK's June 1997 IPO, our desire to participate was frustrated by the high level
of interest it generated among investors, i.e. it was a "hot deal" where we
could not buy much stock and where the price in the aftermarket quickly rose to
a premium we were unwilling to pay.
Fortunately, recent events have given us a better opportunity to own a share
of this business. As the result of a too aggressive acquisition program, JLK
management found itself over extended, and unable to both rapidly assimilate its
purchases as well as continue the dynamic growth of its base business. The
consequence was a flattening of earnings growth and a significant slowing in
revenue growth. The unforgiving growth and momentum oriented shareholders
reacted dramatically to these disappointments and drove the price of JLK from
$39 to $20 in six weeks, with most of the publicly held shares changing hands.
We established our position during this period at an average cost of $22 per
share, believing that JLK's current difficulties will be overcome and that the
inherent superiorities of its business model and its talented management will
enable it to return to its prior record of rapid growth and high returns on
capital.
As can be seen from the table below, Black Box and JLK have the superior
returns and balance sheets, as well as the faster growth, that we are always
striving to find. In addition, their valuations are also more attractive than
average, with PEs on estimated 1998 and hoped-for 1999 earnings well below that
of the average Russell 2500 Index company.
<TABLE>
<CAPTION>
JLK Direct Russell 2500
Black Box Distribution Index
----------------- ----------------- -----------------
<S> <C> <C> <C>
Revenue Growth Rate (5 Yr.) 17% 29% 11%
Return on Equity 33% 24% 15%
Operating Income/ Assets 34% 23% 11%
Debt % of Capital 7% 1% 47%
Recent Price $ 32 $ 20 --
PE (98) 16x 18x 24x
PE (99) 13x 13x 21x
Market Cap $600 Million $500 Million $650 Million
</TABLE>
We are excited by the prospects of these two recently purchased companies, and
optimistic that they will provide rewarding long-term returns to Source Capital
shareholders.
Respectfully submitted,
/s/ ERIC S. ENDE
Eric S. Ende
Senior Vice President and
Chief Investment Officer
July 14, 1998
3
<PAGE>
PORTFOLIO OF INVESTMENTS
June 30, 1998
<TABLE>
<CAPTION>
COMMON STOCKS Shares Cost Value
- ------------------------------------------------------------------------ ----------- -------------- --------------
<S> <C> <C> <C>
PRODUCER DURABLE GOODS -- 18.9%
Denison International plc (ADR)*........................................ 462,600 $ 7,987,091 $ 9,136,350
Donaldson Company, Inc.................................................. 298,800 3,775,799 7,059,150
Federal Signal Corporation.............................................. 178,200 3,948,396 4,332,488
Graco Inc............................................................... 411,000 5,482,222 14,333,625
Holophane Corporation*.................................................. 535,500 9,319,851 13,655,250
IDEX Corporation........................................................ 380,800 9,025,659 13,137,600
Kaydon Corporation...................................................... 426,800 5,736,940 15,071,375
Leggett & Platt, Incorporated........................................... 282,200 3,276,951 7,055,000
-------------- --------------
$ 48,552,909 $ 83,780,838
-------------- --------------
TECHNOLOGY -- 13.6%
Arrow Electronics, Inc.*................................................ 309,100 $ 7,081,054 $ 6,722,925
Belden Inc.............................................................. 302,300 8,927,155 9,257,937
Black Box Corporation*.................................................. 296,400 9,811,348 9,836,775
Channell Commercial Corporation*........................................ 265,000 2,907,500 2,915,000
Galileo International, Inc.............................................. 366,900 9,514,651 16,533,431
KEMET Corporation*...................................................... 531,300 8,797,306 6,989,916
Methode Electronics, Inc. (Class A)..................................... 503,400 7,847,185 7,802,700
-------------- --------------
$ 54,886,199 $ 60,058,684
-------------- --------------
BUSINESS SERVICES & SUPPLIES -- 9.7%
Applied Graphics Technologies, Inc.*.................................... 117,180 $ 3,007,100 $ 5,360,985
Bacou USA, Inc.*........................................................ 319,300 5,231,270 6,645,431
Expeditors International of Washington, Inc............................. 147,400 946,121 6,485,600
JLK Direct Distribution Inc. (Class A)*................................. 380,900 8,518,566 8,332,188
Manpower Inc............................................................ 352,000 10,803,279 10,098,000
Viking Office Products, Inc.*........................................... 199,400 3,145,566 6,256,175
-------------- --------------
$ 31,651,902 $ 43,178,379
-------------- --------------
MATERIALS -- 6.8%
Caraustar Industries, Inc............................................... 437,500 $ 9,448,417 $ 12,632,812
Nucor Corporation....................................................... 180,200 8,707,743 8,289,200
OM Group, Inc........................................................... 219,800 5,398,940 9,066,750
-------------- --------------
$ 23,555,100 $ 29,988,762
-------------- --------------
CONSUMER NON-DURABLE GOODS -- 6.3%
Lancaster Colony Corporation............................................ 360,450 $ 8,300,201 $ 13,652,044
Newell Co............................................................... 129,600 3,111,055 6,455,700
Tupperware Corporation.................................................. 275,000 10,903,667 7,734,375
-------------- --------------
$ 22,314,923 $ 27,842,119
-------------- --------------
HEALTH CARE -- 6.1%
Allergan, Inc........................................................... 234,700 $ 5,056,890 $ 10,884,213
DENTSPLY International Inc.............................................. 399,100 7,846,976 9,977,500
Landauer, Inc........................................................... 209,800 4,280,370 6,267,775
-------------- --------------
$ 17,184,236 $ 27,129,488
-------------- --------------
RETAILING -- 5.9%
Bob Evans Farms, Inc.................................................... 73,800 $ 1,304,143 $ 1,563,637
CVS Corporation......................................................... 140,818 1,598,081 5,483,101
Circuit City Stores, Inc................................................ 228,000 7,025,807 10,687,500
O'Reilly Automotive, Inc.*.............................................. 240,600 3,965,918 8,661,600
-------------- --------------
$ 13,893,949 $ 26,395,838
-------------- --------------
</TABLE>
4
<PAGE>
PORTFOLIO OF INVESTMENTS
<TABLE>
<CAPTION>
Shares or
Face
COMMON STOCKS (CONTINUED) Amount Cost Value
- ------------------------------------------------------------------------ ----------- -------------- --------------
<S> <C> <C> <C>
ENTERTAINMENT -- 4.5%
Carnival Corporation.................................................... 500,800 $ 5,566,251 $ 19,844,200
-------------- --------------
INSURANCE -- 3.4%
Poe & Brown, Inc........................................................ 259,350 $ 4,295,785 $ 9,644,578
Progressive Corporation, The............................................ 37,800 1,463,042 5,329,800
-------------- --------------
$ 5,758,827 $ 14,974,378
-------------- --------------
BANKING -- 2.9%
Norwest Corporation..................................................... 165,176 $ 2,329,752 $ 6,173,453
Wells Fargo & Company................................................... 18,366 4,585,983 6,777,054
-------------- --------------
$ 6,915,735 $ 12,950,507
-------------- --------------
CONSUMER DURABLE GOODS -- 2.5%
Cooper Tire & Rubber Company............................................ 532,600 $ 12,094,815 $ 10,984,875
-------------- --------------
ENERGY -- 1.3%
Schlumberger Limited.................................................... 84,500 $ 5,643,476 $ 5,772,406
-------------- --------------
TOTAL COMMON STOCKS -- 81.9%............................................ $ 248,018,322 $ 362,900,474
-------------- --------------
PREFERRED STOCKS
REAL ESTATE INVESTMENT TRUST -- 1.8%
Crown American Realty Trust............................................. 39,000 $ 1,951,792 $ 2,091,375
Excel Realty Trust, Inc., Cvt. (Class A)................................ 200,000 5,000,000 5,900,000
-------------- --------------
$ 6,951,792 $ 7,991,375
-------------- --------------
CONVERTIBLE BONDS AND DEBENTURES
REAL ESTATE INVESTMENT TRUST -- 2.0%
Alexander Haagen Properties
-- 7 1/2% 2001 (Series A)............................................. $ 1,050,000 $ 916,125 $ 1,015,875
-- 7 1/2% 2001 (Series B)............................................. 2,750,000 2,459,375 2,681,250
Developers Diversified Realty Corporation -- 7% 1999.................... 2,500,000 2,430,625 2,903,125
Rockefeller Center Properties, Inc. -- 0% 2000.......................... 3,005,000 2,296,657 2,351,412
-------------- --------------
$ 8,102,782 $ 8,951,662
-------------- --------------
PRODUCER DURABLE GOODS -- 1.8%
DRS Technologies, Inc.
-- 8 1/2% 1998........................................................ $ 719,000 $ 627,328 $ 722,595
-- 9% 2003............................................................ 2,000,000 2,000,000 2,705,000
Reptron Electronics, Inc. -- 6 3/4% 2004................................ 5,980,000 5,798,575 4,664,400
-------------- --------------
$ 8,425,903 $ 8,091,995
-------------- --------------
HEALTH CARE -- 1.4%
IVAX Corporation -- 6 1/2% 2001......................................... $ 1,500,000 $ 1,256,125 $ 1,350,000
NovaCare, Inc. -- 5 1/2% 2000........................................... 5,250,000 4,809,375 5,000,625
-------------- --------------
$ 6,065,500 $ 6,350,625
-------------- --------------
CONSUMER NON-DURABLE GOODS -- 0.4%
Bell Sports Corp. -- 4 1/4% 2000........................................ $ 2,000,000 $ 1,765,724 $ 1,700,000
-------------- --------------
TECHNOLOGY 0.2%
Read-Rite Corporation -- 6 1/2% 2004.................................... $ 1,000,000 $ 808,750 $ 625,000
-------------- --------------
TOTAL CONVERTIBLE BONDS AND DEBENTURES -- 5.8%.......................... $ 25,168,659 $ 25,719,282
-------------- --------------
</TABLE>
5
<PAGE>
PORTFOLIO OF INVESTMENTS
<TABLE>
<CAPTION>
NON-CONVERTIBLE BONDS AND DEBENTURES Face Amount Cost Value
- ------------------------------------------------------------------------ ----------- -------------- --------------
<S> <C> <C> <C>
CORPORATE -- 5.0%
Advantica Restaurant Group, Inc. -- 11 1/4% 2008........................ $ 2,131,100 $ 2,161,875 $ 2,274,949
Busse Broadcasting Corporation -- 11 5/8% 2000.......................... 2,350,000 2,275,325 2,518,906
DLJ Mortgage Acceptance Corp.
(Series 1997-E Class B) -- 7.5481% 2026+............................... 992,600 875,993 914,433
GPA Delaware Inc. -- 8 3/4% 1998........................................ 2,000,000 2,012,500 1,965,000
Merrill Lynch Mortgage Investors, Inc.
(Series 1992-B) -- 8.3% 2012........................................... 713,300 724,738 719,541
Pacific Lumber Company, The -- 10 1/2% 2003............................. 1,000,000 967,500 1,031,250
Plantronics, Inc. -- 10% 2001........................................... 8,470,000 8,611,244 8,787,625
Trump Atlantic City Associates -- 11 1/4% 2006.......................... 4,000,000 3,925,000 3,890,000
-------------- --------------
$ 21,554,175 $ 22,101,704
-------------- --------------
U.S. GOVERNMENT AND AGENCIES -- 1.6%
Federal Home Loan Mortgage Corporation
-- 6 1/2% 2023 (IO)................................................... $ 3,275,600 $ 413,675 $ 445,277
-- 7% 2023 (CMO)...................................................... 2,203,400 2,241,995 2,204,777
-- 8 1/2% 2024 (REMIC)................................................ 1,173,600 1,180,956 1,174,334
-- 10.15% 2006 (REMIC)................................................ 186,200 184,729 187,364
Federal National Mortgage Association
-- 7% 2008 (REMIC).................................................... 1,147,600 1,140,400 1,147,600
Government National Mortgage Association (Mobile Home)
-- 9 3/4% 2006........................................................ 214,400 227,565 225,120
-- 9 3/4% 2010........................................................ 1,245,900 1,319,054 1,308,195
-- 10 1/4% 2001-2004.................................................. 293,300 312,530 309,890
-------------- --------------
$ 7,020,904 $ 7,002,557
-------------- --------------
TOTAL NON-CONVERTIBLE BONDS
AND DEBENTURES -- 6.6%................................................. $ 28,575,079 $ 29,104,261
-------------- --------------
TOTAL INVESTMENT SECURITIES -- 96.1%.................................... $ 308,713,852 $ 425,715,392
-------------- --------------
--------------
SHORT-TERM INVESTMENTS -- 4.0%
Short-term Corporate Notes:
Bell Atlantic Corporation -- 5.54% 7/31/98............................ $ 2,000,000 $ 1,990,767
Daimler-Benz North America Corp. -- 5.52% 7/13/98..................... 4,000,000 3,992,640
MetLife Funding, Inc.
-- 5 1/2% 7/2/98.................................................... 5,500,000 5,499,160
-- 5.53% 7/21/98.................................................... 5,600,000 5,582,795
State Street Bank Repurchase Agreement -- 5% 07/01/98
(Collateralized by U.S. Treasury Notes -- 6 1/8% 2001,
market value $742,547).............................................. 723,000 723,100
--------------
$ 17,788,462
--------------
TOTAL INVESTMENTS -- 100.1%............................................. $ 443,503,854
Liabilities less other assets -- (0.1)%................................. (593,089)
--------------
TOTAL NET ASSETS -- 100%................................................ $ 442,910,765
--------------
--------------
</TABLE>
* Non-income producing securities
+ Restricted security purchased without registration under the Securities Act of
1933 pursuant to Rule 144A, which generally may be resold only to certain
institutional investors prior to registration.
See notes to financial statements.
6
<PAGE>
MAJOR PORTFOLIO CHANGES
Quarter Ended June 30, 1998
<TABLE>
<CAPTION>
Shares or
Face Amount
----------------
<S> <C>
NET PURCHASES
COMMON STOCKS
Arrow Electronics, Inc................................................ 43,800 shs.
Bacou USA, Inc........................................................ 28,100 shs.
Belden Inc............................................................ 65,400 shs.
Black Box Corporation(1).............................................. 296,400 shs.
Cooper Tire & Rubber Company.......................................... 87,200 shs.
Denison International plc (ADR)....................................... 130,300 shs.
DENTSPLY International Inc............................................ 127,100 shs.
JLK Direct Distribution Inc. (Class A)(1)............................. 380,900 shs.
KEMET Corporation..................................................... 259,600 shs.
Landauer, Inc......................................................... 10,200 shs.
Manpower Inc.......................................................... 63,400 shs.
Viking Office Products, Inc........................................... 51,100 shs.
CONVERTIBLE SECURITY
Read-Rite Corporation -- 6 1/2% 2004.................................. $ 500,000
NET SALES
COMMON STOCKS
Allergan, Inc......................................................... 46,400 shs.
Bob Evans Farms, Inc.................................................. 104,500 shs.
CVS Corporation....................................................... 37,500 shs.
Carnival Corporation.................................................. 7,600 shs.
Franklin Covey Co.(2)................................................. 231,800 shs.
CONVERTIBLE SECURITY
Phoenix Duff & Phelps Corporation -- 6% 2001(2)....................... $ 1,875,000
NON-CONVERTIBLE SECURITIES
Federal Home Loan Mortgage Corporation (REMIC) -- 8 1/2% 2024......... $ 1,441,300
Federal National Mortgage Association (REMIC) -- 8% 2011(2)........... $ 950,300
Genesco Inc. -- 10 3/8% 2003(2)....................................... $ 1,150,000
Primark Corporation -- 8 3/4% 2000(2)................................. $ 6,472,000
</TABLE>
(1) Indicates new commitment to portfolio
(2) Indicates elimination from portfolio
7
<PAGE>
STATEMENT OF ASSETS AND LIABILITIES
<TABLE>
<CAPTION>
June 30, 1998
------------------------------
<S> <C> <C>
ASSETS
Investments at value:
Investment securities -- at market value
(cost $308,713,852) -- Note A.......................................................... $ 425,715,392
Short-term investments -- at cost plus interest earned
(maturities 60 days or less) -- Note A................................................. 17,788,462 $ 443,503,854
--------------
Cash....................................................................................... 126
Receivable for:
Dividends and accrued interest........................................................... $ 1,840,805
Investment securities sold............................................................... 1,197,664
Other.................................................................................... 1,025 3,039,494
-------------- --------------
$ 446,543,474
LIABILITIES
Payable for:
Investment securities purchased.......................................................... $ 3,135,139
Advisory fees............................................................................ 255,535
Accrued dividends -- Preferred Stock..................................................... 196,921
Accrued expenses......................................................................... 45,114 3,632,709
-------------- --------------
TOTAL NET ASSETS -- June 30, 1998............................................................ $ 442,910,765
--------------
--------------
Assets applicable to Preferred Stock at a liquidation preference of
$27.50 per share (asset coverage 818%) -- Note B......................................... $ 54,153,330
--------------
--------------
Net assets applicable to Common Stock -- $52.14 per share.................................. $ 388,757,435
--------------
--------------
SUMMARY OF SHAREHOLDERS' EQUITY
$2.40 Cumulative Preferred Stock -- par value $3 per share;
authorized 3,000,000 shares; outstanding 1,969,212 shares -- Note B...................... $ 5,907,636
Common Stock -- par value $1 per share; authorized 12,000,000 shares;
outstanding 7,455,649 shares -- Note B................................................... 7,455,649
Additional Paid-in Capital................................................................. 300,295,486
Undistributed net realized gain on investments............................................. 21,866,918
Unrealized appreciation of investments..................................................... 117,001,540
Unallocated distributions -- Note A........................................................ (9,616,464)
--------------
TOTAL NET ASSETS -- June 30, 1998............................................................ $ 442,910,765
--------------
--------------
</TABLE>
See notes to financial statements.
8
<PAGE>
STATEMENT OF OPERATIONS
For the six months ended June 30, 1998
<TABLE>
<S> <C> <C>
INVESTMENT INCOME
Income:
Interest................................................ $ 3,409,572
Dividends............................................... 2,263,227
-------------
$ 5,672,799
Expenses -- Note C:
Advisory fees........................................... $ 1,545,390
Transfer agent fees and expenses........................ 150,863
Reports to shareholders................................. 97,737
Directors' fees and expenses............................ 39,000
Legal and auditing fees................................. 34,055
Taxes, other than federal income tax.................... 33,300
Custodian fees and expenses............................. 24,241
Registration and filing fees............................ 16,748
Insurance............................................... 12,195
Other expenses.......................................... 3,881 1,957,410
------------- -------------
Net investment income -- Note A..................... $ 3,715,389
-------------
REALIZED AND UNREALIZED GAIN
ON INVESTMENTS
Realized gain on investments:
Proceeds from sale of investment securities
(Excluding short-term investments with maturities of
60 days or less)....................................... $ 59,424,521
Cost of investment securities sold...................... 42,724,609
-------------
Net realized gain on investments -- Notes A and D..... $ 16,699,912
Unrealized appreciation of investments:
Unrealized appreciation at beginning of period.......... $ 105,473,310
Unrealized appreciation at end of period................ 117,001,540
-------------
Increase in unrealized appreciation of investments.... 11,528,230
-------------
Net realized and unrealized gain on investments..... $ 28,228,142
-------------
NET INCREASE IN NET ASSETS RESULTING
FROM OPERATIONS........................................... $ 31,943,531
-------------
-------------
</TABLE>
See notes to financial statements.
9
<PAGE>
STATEMENT OF CHANGES IN TOTAL NET ASSETS
<TABLE>
<CAPTION>
For the six months ended For the year ended
June 30, 1998 December 31, 1997
----------------------------- -----------------------------
<S> <C> <C> <C> <C>
INCREASE IN TOTAL NET ASSETS
Operations:
Net investment income........................... $ 3,715,389 $ 7,958,519
Net realized gain on investments
-- Notes A and D.............................. 16,699,912 42,884,612
Increase in unrealized appreciation of
investments................................... 11,528,230 33,777,853
------------- -------------
Increase in total net assets resulting
from operations................................. $ 31,943,531 $ 84,620,984
Distributions to Preferred shareholders:
From net investment income...................... (2,363,054) (4,726,109)
Distributions to Common shareholders:
From net investment income...................... $ (5,577,042) $ (2,329,594)
From net realized capital gains................. -- (42,080,024)
Unallocated -- Note A........................... (9,616,464) (15,193,506) -- (44,409,618)
------------- -------------
Proceeds from shares issued for distributions
reinvested by shareholders -- Note B.......... 3,033,687 7,858,423
------------- -------------
Increase in total net assets...................... $ 17,420,658 $ 43,343,680
TOTAL NET ASSETS
Beginning of period, including
undistributed net investment income
of $4,224,707 and $3,321,891.................... 425,490,107 382,146,427
------------- -------------
End of period, including
undistributed net investment income
of $4,224,707 at December 31, 1997.............. $ 442,910,765 $ 425,490,107
------------- -------------
------------- -------------
</TABLE>
See notes to financial statements.
10
<PAGE>
FINANCIAL HIGHLIGHTS
Selected data for a share of Common Stock outstanding throughout each period
<TABLE>
<CAPTION>
Six
Months Year ended December 31,
Ended ---------------------------------------------------------
June 30,
1998 1997 1996 1995 1994 1993
--------- --------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Per share operating performance:
Net asset value at beginning of period............ $ 50.20 $ 45.35 $ 42.58 $ 38.52 $ 41.85 $ 42.87
--------- --------- --------- --------- --------- ---------
Net investment income............................. $ 0.50 $ 1.08 $ 1.30 $ 1.48 $ 1.62 $ 1.94
Net realized and unrealized gain (loss)
on investment securities........................ 3.81 10.50 8.25 6.84 (0.67) 1.32
--------- --------- --------- --------- --------- ---------
Total from investment operations................ $ 4.31 $ 11.58 $ 9.55 $ 8.32 $ 0.95 $ 3.26
--------- --------- --------- --------- --------- ---------
Distributions to Preferred shareholders:
From net investment income...................... $ (0.32) $ (0.65) $ (0.65) $ (0.66) $ (0.69) $ (0.72)
Distributions to Common shareholders:
From net investment income...................... (0.75) (0.32) (0.51) (0.50) (1.14) (1.39)
From net realized gains......................... -- (5.76) (5.62) (3.10) (2.03) (2.21)
In excess of net realized gains................. -- -- -- -- (0.02) --
From Additional Paid-in Capital................. -- -- -- -- (0.41) --
Unallocated..................................... (1.30) -- -- -- -- --
--------- --------- --------- --------- --------- ---------
Total distributions........................... $ (2.37) $ (6.73) $ (6.78) $ (4.26) $ (4.29) $ (4.32)
--------- --------- --------- --------- --------- ---------
Effect of shares issued for distributions
reinvested by shareholders...................... -- -- -- -- $ 0.01 $ 0.04
--------- --------- --------- --------- --------- ---------
Net asset value at end of period.................. $ 52.14 $ 50.20 $ 45.35 $ 42.58 $ 38.52 $ 41.85
--------- --------- --------- --------- --------- ---------
--------- --------- --------- --------- --------- ---------
Per share market value at end of period........... $ 53.38 $ 51.06 $ 45.50 $ 41.88 $ 37.00 $ 43.25
Total investment return(1)........................ 8.7% 26.9% 24.5% 23.4% (6.5)% (1.8)%
Net asset value total return(2)................... 8.0% 25.4% 21.9% 20.7% 0.6% 6.3%
Ratios/supplemental data:
Net assets at end of period (in thousands)...... $442,911 $425,490 $382,146 $362,087 $329,427 $330,465
Ratio of expenses to average net assets......... 0.88%(3) 0.87% 0.89% 0.91% 0.96% 0.95%
Ratio of net income to average net assets....... 1.66%(3) 1.95% 2.52% 3.04% 3.36% 3.86%
Portfolio turnover rate......................... 22.23%(3) 27.46% 41.04% 51.44% 71.39% 73.91%
Average brokerage commission per share.......... $0.0577 $0.0586 $0.0589 -- -- --
Preferred Stock:
Total shares outstanding(4)....................... 1,969,212 1,969,212 1,969,212 1,969,212 1,969,212 1,969,212
Asset coverage per share(4)....................... $224.92 $216.07 $194.06 $183.87 $167.29 $167.82
Involuntary liquidation preference per share...... $27.50 $27.50 $27.50 $27.50 $27.50 $27.50
Average market value per share(5)................. $30.09 $28.72 $28.50 $28.00 $27.89 $30.24
</TABLE>
(1) Based on market value per share, adjusted for reinvestment of distributions
and taxes
(2) Based on net asset value per share, adjusted for reinvestment of
distributions and taxes
(3) Annualized
(4) Information shown as of the end of the period
(5) The average of all month-end market values during each period
See notes to financial statements.
11
<PAGE>
NOTES TO FINANCIAL STATEMENTS
June 30, 1998
NOTE A--SIGNIFICANT ACCOUNTING POLICIES
The Company is registered under the Investment Company Act of 1940 as a
diversified, closed-end management investment company. The investment objective
of the Company is to seek maximum total return for Common shareholders from both
capital appreciation and investment income to the extent consistent with
protection of invested capital and provision of sufficient income to meet the
dividend requirements of Preferred shareholders. The significant accounting
policies followed by the Company in the preparation of its financial statements
include the following:
1. SECURITIES VALUATION--Securities, including any outstanding written
call options, listed or traded on a national securities exchange or on the NAS-
DAQ National Market System are valued at the last sale price on the last
business day of the period, or, if there was not a sale that day, at the mean
between the most recent bid and asked prices. Securities which are unlisted and
debt and convertible securities listed on a national securities exchange for
which the over-the-counter market more accurately reflects the securities' value
in the judgment of the Company's officers, are valued at the mean between the
most recent bid and asked prices or other ascertainable market value. Short-term
investments with maturities of 60 days or less are valued at cost plus interest
earned, which approximates market value. Restricted securities and securities
for which market quotations are not readily available are valued at fair value
as determined in good faith by, or under the direction of, the Board of
Directors.
2. FEDERAL INCOME TAX--No provision for federal taxes is considered
necessary because the Company has elected to be taxed as a "regulated investment
company" under the Internal Revenue Code, and intends to maintain this
qualification and to distribute each year all of its taxable net investment
income and taxable net realized gain on investments to its shareholders in
accordance with the minimum distribution requirements of the Code.
3. UNALLOCATED DISTRIBUTIONS-- Unallocated distributions represent
distributions paid to Common shareholders during the period from source(s) other
than net investment income. Such source(s) will be determined by the results of
operations for the entire fiscal year and will be paid-in capital, except to the
extent of any net realized capital gains for the fiscal year.
4. USE OF ESTIMATES--The preparation of the financial statements in
accordance with generally accepted accounting principles requires management to
make estimates and assumptions that affect the amounts reported. Actual results
could differ from those estimates.
5. OTHER--Securities transactions are accounted for on the date
securities are purchased or sold. Dividend income is recorded on the ex-dividend
date. Interest income and expenses are recorded on an accrual basis. Dividends
payable by the Company on the Preferred Stock are recorded on an accrual basis
and distributions payable on the Common Stock are recorded on the ex-dividend
date.
NOTE B--CAPITAL STOCK
The Preferred Stock is entitled in liquidation to $27.50 per share plus
accrued dividends and may be called for redemption, at the discretion of the
Company, at $27.50 per share plus accrued dividends. Dividends may not be
declared on the Common Stock if Preferred dividends are in arrears or if the
Preferred Stock would not thereafter have an asset coverage of 200% or more.
The Company issued 58,390 shares of Common Stock under its Reinvestment
Plan for Common and Preferred shareholders during the six months ended June 30,
1998.
NOTE C--ADVISORY FEES AND OTHER AFFILIATED TRANSACTIONS
Pursuant to an investment advisory agreement, the Company pays First
Pacific Advisors, Inc. ("Investment Adviser") monthly investment advisory fees
calculated at an annual rate of .725% for the first $100 million of total net
assets, .700% for the next $100 million of total net assets, and .675% for any
total net assets in excess of $200 million. The Agreement obligates the
Investment Adviser to reduce its fee to the extent necessary to reimburse the
Company for any annual expenses (exclusive of interest, taxes, the cost of any
supplementary statistical and research information, legal expenses related to
portfolio securities, and extraordinary expenses such as litigation) in excess
of 1 1/2% of the first $30 million and 1% of the remaining average total net
assets of the Company for the year.
For the six months ended June 30, 1998, the Company paid aggregate fees of
$39,000 to all Directors who are not affiliated persons of the Investment
Adviser. During the six months ended June 30, 1998, the Company incurred legal
fees of $4,980 payable to O'Melveny & Myers LLP, counsel for the Company. A
Director of the Company is of counsel to, and a retired partner of, that firm.
The Officers of the Company are also officers of the Investment Adviser.
NOTE D--PURCHASES AND SALES OF SECURITIES
Cost of purchases of investment securities (excluding short-term corporate
notes with maturities of 60 days or less) aggregated $46,635,109 for the six
months ended June 30, 1998. Cost of investment securities owned at June 30, 1998
was the same for federal income tax and financial reporting purposes. Gains and
losses are based on the specific certificate identification method.
NOTE E--YEAR 2000
Like other investment companies, financial and business organizations and
individuals around the world, the Company could be adversely affected if the
computer systems used by the Adviser and other service providers do not properly
process and calculate date-related information and data from and after January
1, 2000. This is commonly known as the "Year 2000 Problem." The Adviser is
taking steps that it believes are reasonably designed to address the Year 2000
Problem with respect to computer systems that it uses and to obtain reasonable
assurances that comparable steps are being taken by the Company's other major
service providers. At this time, however, there can be no assurance that these
steps will be sufficient to avoid any adverse impact to the Company.
12
<PAGE>
RESULTS OF ANNUAL MEETING
Following is a list of matters voted upon and the results of those votes
cast at the annual meeting of shareholders held May 4, 1998:
1. With respect to the election of five directors by the holders of Common
Stock, $1.00 par value, and election of two directors by the holders of
$2.40 Cumulative Preferred Stock, $3.00 par value:
<TABLE>
<CAPTION>
VOTES FOR VOTES WITHHELD
------------ --------------
<S> <C> <C>
COMMON
Wesley E. Bellwood.................................................................................... 5,607,639 66,742
Julio J. de Puzo, Jr.................................................................................. 5,610,135 66,742
David Rees............................................................................................ 5,610,927 66,742
Robert L. Rodriguez................................................................................... 5,607,639 66,742
Lawrence J. Sheehan................................................................................... 5,608,685 66,742
PREFERRED
Willard H. Altman..................................................................................... 1,519,009 23,638
Charles W. Stanton.................................................................................... 1,519,029 23,638
</TABLE>
2. With respect to continuation of the Investment Advisory Agreement, a
total of 7,049,883 shares voted for, 45,216 shares voted against and
123,305 shares abstained.
3. With respect to the selection of Ernst & Young LLP as independent
auditors for the Company for the fiscal year, a total of 7,112,921 shares
voted for, 27,165 shares voted against and 78,318 shares abstained.
No broker non-votes were received with respect to any of the matters voted
upon above.
13
<PAGE>
<TABLE>
<S> <C>
SOURCE CAPITAL, INC. BULK RATE
11400 West Olympic Boulevard, Suite 1200 U.S. POSTAGE
Los Angeles, California 90064 PAID
CMSS
</TABLE>
