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[LOGO]
SOURCE CAPITAL, INC.
1998
ANNUAL REPORT
for the year ended December 31
<PAGE>
DIRECTORS
Willard H. Altman
Wesley E. Bellwood
Julio J. de Puzo, Jr.
David Rees
Robert L. Rodriguez
Paul G. Schloemer
Lawrence J. Sheehan
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
INDEPENDENT AUDITORS
Ernst & Young 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
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SUMMARY FINANCIAL INFORMATION
<TABLE>
<CAPTION>
For the year ended December 31,
--------------------------------------------------------
1998 1997
--------------------------- ---------------------------
Total Total
Net Per Common Net Per Common
Assets Share Assets Share
-------------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
Beginning of year...................................................... $425,490,107 $ 50.20 $382,146,427 $ 45.35
Net gain on investments, realized and unrealized....................... 18,017,166 2.37 76,662,465 10.50
Income available to Common shareholders................................ 1,891,524 0.25 3,232,410 0.43
Distributions to Common shareholders................................... (34,408,899) (4.62) (44,409,618) (6.08)
Proceeds from shares issued for distributions reinvested by
shareholders......................................................... 6,786,649 0.03 7,858,423 --
-------------- ----------- -------------- -----------
Net changes during year............................................ $ (7,713,560) $ (1.97) $ 43,343,680 $ 4.85
-------------- ----------- -------------- -----------
End of year............................................................ $417,776,547 $ 48.23 $425,490,107 $ 50.20
-------------- ----------- -------------- -----------
-------------- ----------- -------------- -----------
Common market price per share.......................................... 49 1/16 51 1/16
Common market premium to net asset value............................... 1.7% 1.7%
Preferred asset coverage............................................... 771% 786%
Preferred liquidation preference per share............................. $27.50 $27.50
Preferred market price per share....................................... 29 13/16 29
</TABLE>
<PAGE>
DESCRIPTION OF THE COMPANY
SOURCE CAPITAL, INC. is a major diversified, publicly traded investment
company with total net assets of approximately $418,000,000. Its investment
portfolio includes a wide range of securities with primary emphasis on common
stock 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 7,540,060
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.
DIVIDEND REINVESTMENT PLAN
Holders of record (other than brokers or nominees of banks and other financial
institutions) of Common and Preferred Stock are eligible to participate in the
Dividend Reinvestment Plan ("Plan"), pursuant to which distributions to
shareholders are paid in or reinvested in shares of Common Stock of the Company
("Dividend Shares"). The Chase Manhattan Bank ("Agent") c/o ChaseMellon
Shareholder Services, L.L.C., Investment Services, P.O. Box 3338, South
Hackensack, New Jersey 07606-1938, acts as agent for participants under the
Plan.
A shareholder may join the Plan by signing and returning an authorization form
which may be obtained from the Agent. A shareholder may elect to withdraw from
the Plan at any time by written notice to the Agent and thereby elect to receive
cash in lieu of Dividend Shares. There is no penalty for withdrawal from the
Plan and shareholders who have previously withdrawn from the Plan may rejoin at
any time. The Company reserves the right to amend or terminate the Plan.
Purchases of the Company's shares are made by the Agent, on behalf of the
participants in the Plan, promptly after receipt of funds, and in no event later
than 30 days from such receipt except when restricted under applicable federal
securities laws. The Agent purchases outstanding shares in the market when the
price plus estimated commissions of the Company's Common Stock on the NYSE is
lower than the Company's most recently calculated net asset value per share. To
the extent that outstanding shares are not available at a cost of less than per
share net asset value, the Agent, on behalf of the participants in the Plan,
accepts payment of the dividend, or the remaining portion thereof, in authorized
but unissued shares of Common Stock of the Company on the payment date. Such
shares are issued at a per share price equal to the higher of (1) the net asset
value per share on the payment date, or (2) 95% of the closing market price per
share on the payment date. There are no brokerage charges with respect to shares
issued directly by the Company to satisfy the dividend reinvestment
requirements. However, each participant pays a pro rata share of brokerage
commissions incurred with respect to the Agent's open market purchases of
shares. In each case, the cost per share of shares purchased for each
shareholder's account is the average cost, including brokerage commissions, of
any shares purchased in the open market plus the cost of any shares issued by
the Company.
For Federal income tax purposes, shareholders who reinvest distributions are
treated as receiving distributions in an amount equal to the fair market value,
determined as of the payment date, of the shares received if the shares are
purchased from the Company. Such value may exceed the amount of the cash
distribution that would have been paid. If outstanding shares are purchased in
the open market, the taxable distribution equals the cash distribution that
would have been paid. In either event, the cost basis in the shares received
equals the amount recognized as a taxable distribution.
In the case of foreign participants whose dividends are subject to United
States income tax withholding and in the case of any participants subject to 31%
federal backup withholding, the Agent will reinvest dividends after deduction of
the amount required to be withheld.
All record holders of Common Stock are also offered the opportunity, on a
voluntary basis, to send in cash payments of not less than $100 each up to a
total of $7,500 per month to purchase additional shares of the Common Stock of
the Company through participation in the Cash Investment Plan ("Cash Plan").
Under the Cash Plan, shares are purchased in the market and no shares are issued
by the Company. A brochure describing the terms and conditions of the Cash Plan,
including fees and expenses, is available from the Agent.
1
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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
1998 INVESTMENT PORTFOLIO RETURNS
Total net assets of Source Capital amounted to $417,776,547 at December 31,
1998. After providing for Preferred stock equity, Common equity amounted to
$363,623,217 or $48.23 of net asset value per Common share. This compared with
total net assets of $425,490,107, Common equity of $371,336,777 and net asset
value per Common share of $50.20 one year ago. These changes reflect payments to
Common and Preferred shareholders totaling $39,135,008. As a result, Source
Capital achieved a total investment return during 1998 of 5.8% on its Common net
asset value (6.4% on total net assets) with both figures reflecting the
reinvestment of dividends and distributions.
The table at the bottom of this page compares Source Capital's investment
results with the returns of several well-known indices of securities prices. All
the percentage changes shown represent total investment returns from both income
and appreciation (depreciation) calculated on the basis of reinvesting all
dividends and distributions.
NET INVESTMENT INCOME
As has been the case for the past several years, net investment income has
continued to decline. Most of this decline has occurred on the interest side of
net investment income while the dividend side has remained essentially flat.
Holdings in commercial paper have declined this year as the asset allocation to
equities has increased with a resulting decline in the cash position.
Specifically, net investment income amounted to $1,420,270 and $6,617,633 for
the fourth quarter and full year, respectively, compared with $1,964,401 and
$7,958,519 in 1997. After providing for Preferred dividends, net investment
income per Common share totaled $0.03 and $0.25 for the fourth quarter and full
year, respectively, compared with $0.09 and $0.43 earned in the corresponding
periods of 1997.
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<TABLE>
<CAPTION>
SOURCE CAPITAL STOCK MARKET INDICES FIXED-INCOME INDICES
------------------- ------------------------ ----------------------------------
TOTAL COMMON RUSSELL S&P LEHMAN BROTHERS TREASURY
PERIOD NET ASSETS EQUITY 2500 500 DJIA GOVT/CORP BOND INDEX BILL YIELDS
- --------------------------------------------- ---------- ------ ------- ------ ------ -------------------- -----------
<S> <C> <C> <C> <C> <C> <C> <C>
1998 + 6.4% + 5.8% + 0.4% +28.6% +18.2% + 9.5% + 5.1%
1997 +23.0 +25.4 +24.4 +33.4 +24.9 + 9.8 + 5.2
1996 +20.0 +21.9 +19.0 +23.0 +28.9 + 2.9 + 5.3
1995 +18.7 +20.7 +31.7 +37.6 +36.9 +19.2 + 5.7
1994 + 2.0 + 0.6 - 1.1 + 1.3 + 5.0 - 3.5 + 4.2
1993 + 6.7 + 6.3 +16.5 +10.0 +17.0 +11.0 + 3.1
1992 +12.5 +13.3 +16.2 + 7.6 + 7.4 + 7.6 + 3.6
1991 +19.7 +22.2 +46.7 +30.5 +24.3 +16.1 + 5.8
1990 - 1.2 - 3.2 -14.9 - 3.1 - 0.5 + 8.3 + 7.8
1989 +21.1 +23.9 +19.4 +31.7 +32.3 +14.2 + 8.2
1988 +15.2 +16.8 +22.7 +16.6 +16.2 + 7.6 + 6.2
1987 + 3.0 + 1.7 - 4.7 + 5.3 + 5.6 + 2.3 + 5.9
1986 +12.8 +13.9 +12.0 +18.7 +27.3 +15.6 + 6.0
1985 +24.2 +28.5 +31.9 +31.7 +33.7 +21.3 + 7.5
1984 +11.9 +12.8 - 4.1 + 6.3 + 1.4 +15.0 + 9.6
1983 +18.4 +21.3 +27.7 +22.6 +26.1 + 8.0 + 8.6
1982 +21.6 +26.1 +26.7 +21.6 +27.2 +31.1 +10.7
1981 +14.2 +16.0 + 3.0 - 4.9 - 3.7 + 7.3 +14.1
1980 +19.2 +23.1 +34.3 +32.5 +22.2 + 3.0 +11.6
1979 +26.6 +35.0 +38.4 +18.6 +10.7 + 2.3 +10.3
1978 +16.1 +19.7 N/A + 6.6 + 2.8 + 1.2 + 7.2
1977 +13.0 +15.1 N/A - 7.2 -12.9 + 3.0 + 5.4
Annual Compound
Rate of Return:
20 years +14.5 +16.2 +16.2 +17.8 +17.4 +10.2 + 7.2
22 years +14.5 +16.3 N/A +16.0 +15.2 + 9.4 + 7.1
</TABLE>
2
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DISTRIBUTIONS TO COMMON SHAREHOLDERS
The distribution rate on Source Capital Common Stock is currently at the $4.20
annual rate which has been in effect since June 1998. Source Capital's
distribution policy, initiated in June 1976, calls for payments to Common
shareholders of approximately 10% of the Common Stock's ongoing net asset value.
Since the adoption of this policy almost 23 years ago, continuing growth in net
asset value has led to 18 increases in the distribution rate totaling 200%. This
growth was achieved despite payments to shareholders in excess of net investment
income of $347,772,513 or $52.85 per Common share, plus payment of federal
income tax on the retained portion of net realized long-term gains of
$36,198,677 or $5.99 per Common share. As we have repeatedly pointed out,
maintenance of the current $4.20 Common distribution rate is dependent on
achieving investment results which will sustain a net asset value of
approximately $42.00.
Capital gains are the eventual result of successful investments. As in recent
years, changes in relative market valuation as well as changing prospects of
individual companies have led us to sell certain holdings in 1998 and these
sales have resulted in the realization of significant net capital gains. We
believe that 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.
As a result of these changes, the Company realized $35,506,929 in net capital
gains in 1998. Distribution of these gains required payment of a special
distribution of $0.47 per share to Common shareholders on December 15, 1998 in
addition to the $1.05 per share regular quarterly distribution to Common
shareholders. Detailed tax information is presented on page 11.
MARKET PRICES AND SHAREHOLDER RETURNS
In the long run, the future returns for Source Capital Common shareholders
will depend primarily on how well we manage the firm's investment portfolio. The
longer the period of time involved, the more important portfolio investment
returns will be in determining shareholder returns. However, in the short run,
changes in the market price of Source Capital Common shares which deviate from
the underlying changes in net asset value can cause shareholder returns to be
either enhanced or diminished. Since the Common market premium to net asset
value was virtually unchanged at December 31, 1998 from that at December 31,
1997, the market return for the year did not deviate significantly from the net
asset value return.
The following table presents 1998 market returns for both Common and Preferred
shareholders:
<TABLE>
<CAPTION>
Common Preferred
Stock Stock
----------- -----------
<S> <C> <C>
Change in Market Value:
NYSE Closing Price
-- 12/31/98.............. $ 49.0625 $ 29.8125
NYSE Closing Price
-- 12/31/97.............. $ 51.0625 $ 29.0000
----------- -----------
Net change in 1998......... $ (2.0000) $ 0.8125
Distributions in 1998........ 4.6200 2.4000
----------- -----------
Total return -- Amount....... $ 2.6200 $ 3.2125
Total return -- Percent...... 5.1% 11.1%
</TABLE>
Common shareholders who participated in the Company's Automatic Reinvestment
Plan experienced a positive return of 5.8% during 1998. Furthermore, on a long-
term basis those shareholders who participated in the Automatic Reinvestment
Plan during each of the 22 years since its inception experienced an annual
compound rate of return of 18.2%.
COMMENTARY
Three things are certain in life -- death, taxes, and the underperformance of
small-cap stocks. This was demonstrated once again in 1998, and even more
dramatically than in earlier years. (We are referring only to small-cap
underperformance, and will save any discussion of death and taxes for a possible
future shareholder letter.) As a result, the stock indexes dominated by a small
number of very large companies greatly outperformed those indexes more
representative of the great mass of stocks.
<TABLE>
<CAPTION>
1998
-----------
<S> <C>
Nasdaq 39.6%
S&P 500 28.8%
Russell 2500 0.4%
Russell 2000 (2.6)%
</TABLE>
An alternative way of showing these differences is to look at the 1998 price
performance of all publicly traded stocks based on market cap tiers, from those
over $20 billion in size (about 100 companies), to those with market caps under
$250 million (over 5,000 companies). The differences are astounding.
<TABLE>
<CAPTION>
1998
Unweighted
Capitalization Tier Performance
- ------------------------------------- --------------
<S> <C>
GREATER THAN 20 Billion 25.9%
5 - 20 Billion 6.2%
2 - 5 Billion (6.1)%
250 Million - 2 Billion (16.6)%
LESS THAN 250 Million (24.1)%
</TABLE>
Source: Salomon Smith Barney
Given that most of the stocks in Source's portfolio have market caps between
$250 million and $5 billion, we are relatively pleased with Source's performance
for 1998 --
3
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a 5.8% gain in net assets per Common share. This represents the third
consecutive year the portfolio has outperformed the Russell 2500, the index
which is the closest match to the market cap, and portfolio weightings of the
companies we hold. The Russell 2500 excludes the 500 largest companies in the
Russell 3000 Index, which is comprised of the 3,000 largest publicly traded U.S.
Companies.
<TABLE>
<CAPTION>
1996 1997 1998
--------- --------- ---------
<S> <C> <C> <C>
Source Capital 21.9% 25.4% 5.8%
Russell 2500 19.0% 24.4% 0.4%
</TABLE>
It is important to realize that the strong performance of the "stock market" in
1998 was driven by a tiny group of companies, many technology related, which had
extraordinary gains. The ten largest S&P 500 companies were up 38% in 1998 --
they account for 20% of the S&P's market cap. The ten largest Nasdaq companies,
up 115% in 1998, now account for 40% of that index's market cap. Viewed slightly
differently, fifteen companies accounted for over half of the S&P's gain in
1998, while only ten companies produced over two-thirds of the Nasdaq's gain.
In selecting the 35-40 companies that are currently in Source's portfolio, we
are able to choose among several thousand, all of which are large enough for us
to buy a full position -- about $10 million of stock. Most of these 3,000 or so
companies were down in 1998, yet the "market," as determined by only a few dozen
firms, was up dramatically.
Not surprisingly, the result of several years of outsized gain by these large
firms is that they now have extraordinarily high valuations. The ten largest S&P
companies have an average PE of 48x. Of the ten top Nasdaq companies, the seven
which actually made money in the past year had an average PE of 70x. No Internet
companies are included in these average PEs. Their valuations are much higher --
AOL at 310x, Yahoo at 525x, etc. In contrast, the average Russell 2500 stock has
a 25x PE. The average PE in the Source portfolio is 18x.
When we look at the last 75 years of stock market history, we see that
prolonged periods of small stock relative underperformance have eventually been
followed by long periods of outperformance. The obvious question of WHEN this
change will take place is unfortunately impossible to answer. We can be sure,
however, that it will occur.
The 5-year periods of small-stock underperformance which stand out in the
historical record are: 1928-1932, 1970-1974, 1986-1990, and 1994-1998. During
the five years following each of these (excluding of course 1994-1998), small
stocks outperformed large stocks by an average of over 25% a year. Comparing
relative valuations of larger and smaller companies -- using Price/ Earnings,
Price/Book, and PE/Growth Rate -- we find that small stocks are relatively
cheaper than they were in 1990, the most recent time of valuation extremes and
one more relevant to the present than the 1930s.
During the course of 1998, we reduced the number of common stock holdings from
43 to 36, although the percentage of the portfolio represented by equities is
actually up modestly from the end of 1997. We believe that this culling of the
portfolio has resulted in a group of stronger businesses, but with no compromise
on valuation or any sacrifice in diversification.
One of the most significant of our new purchases is HON INDUSTRIES, a
manufacturer of office furniture headquartered in Muscatine, Iowa. Hon dominates
the low-end, or "transactional" segment of the office furniture business, where
orders are for small quantities, and price and immediate delivery are key
purchase considerations. This is in contrast to the high-end, or "contract"
furniture segment, dominated by Steelcase, Herman Miller, Knoll and Haworth.
Here the selling process is long, architects and designers are often involved,
and the typical sale is of a large quantity of furniture to a large corporation.
Jack Michaels, who became Hon's CEO in 1991, has made a number of changes which
have improved Hon's operations, including significant productivity improvements,
expansion of distribution, and strategic acquisitions which expanded the product
line. As a result, since 1991 Hon has steadily increased its market share,
tripled profits and earned a return on equity of over 25%, while maintaining a
strong balance sheet.
Our opportunity to buy Hon at a modest valuation was the result of the market's
concern that furniture industry growth was dramatically slowing from the strong
gains of recent years. While we recognize this possibility, we note that office
furniture has not been an especially cyclical business -- the industry has had
only two down years in the past twenty-five. In addition, we have a high degree
of confidence in Hon's ability to outperform its competitors, to continue to
earn excellent returns even in a weaker environment, and to seize the
opportunities that a downturn could present. We therefore were pleased that we
could establish a substantial position in Hon at an average cost of about $22
per share, only 13x 1998 earnings. Hon Industries is now Source Capital's sixth
largest position.
Another major new position is ADOBE SYSTEMS, a software developer in San Jose,
California. Adobe's products dominate the computer manipulation of graphic and
photographic images, as well as desktop publishing. Originally developed for
Macintosh computers, Adobe has adapted its products for PCs as well, and its
competitive strength is comparable in this market segment. Software is often an
area where market share changes are glacial, and recurring revenue can be
realized from selling program upgrades to the large user base.
Adobe's stock was weak last summer because of market worries about its pace of
new product introductions, as well as its history of quarterly earnings
surprises. We were
4
<PAGE>
attracted by its strong competitive position and reliable revenue flow, and felt
that the new product story was more likely than not to be better than Wall
Street's abysmal expectations. In addition, with $7 per share in cash and no
debt, Adobe was modestly valued at our average cost of $34 per share compared to
1998 earnings of $1.85 and 1999 estimates of about $2.40. Adobe Systems is
Source's third biggest holding.
In addition to buying new positions in 1998, we also sold some existing ones.
In many cases these were companies which had performed up to our expectations
and whose stock prices fully reflected this. In several others, three of which I
will discuss in more detail, we were disappointed in both the stock market
performance and the operation of the business.
TOYS R US, initially purchased in the first quarter of 1997 is the best-known
specialty store selling toys and other children's products. It has leading
market shares in both the United States and many foreign countries, and a
powerful brand name. At the time of our purchase, Toys R Us was facing a
competitive challenge from its discount store competitors, primarily Wal-Mart
and Target, as well as from the gradual evolution from traditional toys towards
electronic ones. We anticipated that improvements in store layout and
merchandising would permit Toys R Us to hold on to its leading position, and
enhance its profitability. Unfortunately, the changes Toys R Us made were
inadequate to halt its erosion in market share or profits. We sold our position
during the first quarter of 1998 at approximately the same price that we had
paid a year earlier.
A second disappointment was TUPPERWARE, first purchased in early 1996 and
finally sold at a substantial loss during the third quarter of 1998. Although
Tupperware had a long record of steady growth and high profitability in its
foreign operations (but break-even results in its much smaller and less
important U.S. business), our purchase seemed to coincide with a severe
deterioration in the performance of its operations in Asia and Latin America.
Though some of this can be blamed on the economic environment, most of it
appears to us to be the result of management error. More recently, Tupperware's
important European business has also declined, though to a much lesser extent.
We clearly overestimated management's ability (key senior managers had extensive
direct marketing experience including a new CEO who had been hired two years
earlier from Avon) and the inherent strength of the Tupperware business (based
on the powerful brand name and the steady growth and high profitability of its
foreign operations where many markets were largely untapped).
Another company which disappointed us was FRANKLIN COVEY, a producer and
marketer of training seminars and products designed to improve individual
productivity through effective time management skills. The heart of the system
was the Franklin Day Planner, sold through a network of retail stores and
catalogs, as well as through corporate training seminars. The company had a
strong balance sheet with no net debt, excess cash, strong cash flow, and
returns-on-equity of 25%.
We invested in the company in mid-1995 at an average cost of $21 per share, a
trailing PE of only 14x. However, subsequent to our initial investment, problems
began to surface as a result of what management was doing with the excess cash
the company was generating. Starting with a small acquisition in mid-1994 that
appeared to make strategic sense (a training company for the improvement of oral
and written business communication skills), the company pursued an acquisition
strategy to improve sales and expand the product line. Unfortunately, this led
to a number of sales force integration problems that seemed to be repeated with
each subsequent acquisition so that earnings growth came to a grinding halt.
Although still generating decent earnings, the company was no longer growing the
bottom line and the company became mired in a valuation range at a discount to
the market. Although we hung on for several years, believing management could
solve its operating problems, we eventually liquidated the position in mid-1998
at an average price of $25 -- not the result that we originally envisioned.
Companies with strong cash flows must be able to successfully reinvest that cash
flow in the business. When a company chooses to pursue a new path of growth via
acquisition, but has not demonstrated any previous acquisition experience, close
attention must be paid to any signs of integration difficulties.
We hope that our discussion of companies that we have recently found attractive
as well as those that failed to meet our expectations provides our shareholders
with a better understanding of our investment process. We continue to focus our
investments on soundly financed companies earning high returns on invested
capital. Our approach is based on purchasing high earning power at a discount
and allowing the successful operation of an outstanding business to generate
returns over time. The implementation of this approach requires an ongoing
revalidation of our original judgments regarding a company. The discussion of
three of our sales during 1998 highlights the importance of management, of
successful reinvestment of cash flow, and above all, of a sustainable high
return business.
Respectfully submitted,
/s/ Eric S. Ende
Eric S. Ende
Senior Vice President and
Chief Investment Officer
February 15, 1999
5
<PAGE>
PORTFOLIO OF INVESTMENTS
December 31, 1998
<TABLE>
<CAPTION>
COMMON STOCKS Shares Cost Value
- ------------------------------------------------------------------------ ----------- -------------- --------------
<S> <C> <C> <C>
PRODUCER DURABLE GOODS -- 18.6%
Crane Co................................................................ 175,600 $ 4,842,634 $ 5,300,925
Denison International plc (ADR)*++...................................... 583,300 9,571,278 7,291,250
Donaldson Company, Inc.................................................. 298,800 3,775,799 6,200,100
Federal Signal Corporation.............................................. 178,200 3,948,396 4,878,225
Graco Inc............................................................... 434,500 5,961,608 12,817,750
Holophane Corporation*++................................................ 535,500 9,319,851 13,755,656
IDEX Corporation........................................................ 428,500 10,174,696 10,498,250
Kaydon Corporation...................................................... 421,800 5,631,575 16,898,363
-------------- --------------
$ 53,225,837 $ 77,640,519
-------------- --------------
BUSINESS SERVICES & SUPPLIES -- 15.0%
Applied Graphics Technologies, Inc.*.................................... 744,380 $ 8,133,331 $ 12,282,270
Bacou USA, Inc.*........................................................ 331,400 5,415,146 7,125,100
Expeditors International of Washington, Inc............................. 147,400 946,121 6,190,800
HON INDUSTRIES Inc...................................................... 566,600 12,312,776 13,562,988
JLK Direct Distribution Inc. (Class A)*................................. 730,700 13,744,134 7,444,006
Manpower Inc............................................................ 352,000 10,803,279 8,866,000
Office Depot, Inc.*..................................................... 192,600 3,004,466 7,114,162
-------------- --------------
$ 54,359,253 $ 62,585,326
-------------- --------------
TECHNOLOGY -- 14.5%
Adobe Systems Incorporated.............................................. 317,500 $ 10,771,879 $ 14,843,125
Belden Inc.............................................................. 519,500 13,012,291 11,006,906
Channell Commercial Corporation*........................................ 265,000 2,907,500 2,219,375
Galileo International, Inc.............................................. 388,400 10,011,112 16,895,400
KEMET Corporation*...................................................... 695,200 10,637,804 7,821,000
Methode Electronics, Inc. (Class A)..................................... 503,400 7,847,185 7,865,625
-------------- --------------
$ 55,187,771 $ 60,651,431
-------------- --------------
MATERIALS -- 7.3%
Caraustar Industries, Inc............................................... 412,500 $ 8,698,417 $ 11,782,031
Nucor Corporation....................................................... 180,200 8,707,743 7,793,650
OM Group, Inc........................................................... 302,600 8,028,453 11,044,900
-------------- --------------
$ 25,434,613 $ 30,620,581
-------------- --------------
DISTRIBUTION -- 5.8%
Arrow Electronics, Inc.*................................................ 370,000 $ 7,892,186 $ 9,874,375
Black Box Corporation*.................................................. 380,900 12,046,589 14,426,588
-------------- --------------
$ 19,938,775 $ 24,300,963
-------------- --------------
HEALTH CARE -- 5.7%
Allergan, Inc........................................................... 105,800 $ 1,859,026 $ 6,850,550
DENTSPLY International Inc.............................................. 399,100 7,846,976 10,276,825
Landauer, Inc........................................................... 209,800 4,280,370 6,792,275
-------------- --------------
$ 13,986,372 $ 23,919,650
-------------- --------------
RETAILING -- 5.2%
Circuit City Stores, Inc................................................ 223,000 $ 6,855,552 $ 11,136,062
O'Reilly Automotive, Inc.*.............................................. 225,600 3,643,043 10,659,600
-------------- --------------
$ 10,498,595 $ 21,795,662
-------------- --------------
ENTERTAINMENT -- 3.0%
Carnival Corporation.................................................... 261,600 $ 2,864,888 $ 12,556,800
-------------- --------------
</TABLE>
6
<PAGE>
PORTFOLIO OF INVESTMENTS
December 31, 1998
<TABLE>
<CAPTION>
Shares or
Face
COMMON STOCKS (CONTINUED) Amount Cost Value
- ------------------------------------------------------------------------ ----------- -------------- --------------
<S> <C> <C> <C>
CONSUMER NON-DURABLE GOODS -- 2.8%
Lancaster Colony Corporation............................................ 360,450 $ 8,300,201 $ 11,579,456
-------------- --------------
BANKING -- 2.3%
Wells Fargo & Company................................................... 241,836 $ 4,243,949 $ 9,658,326
-------------- --------------
INSURANCE -- 2.2%
Poe & Brown, Inc........................................................ 259,350 $ 4,295,785 $ 9,061,041
-------------- --------------
ENERGY -- 1.0%
Schlumberger Limited.................................................... 84,500 $ 5,643,476 $ 3,897,562
-------------- --------------
TOTAL COMMON STOCKS -- 83.4%............................................ $ 257,979,515 $ 348,267,317
-------------- --------------
PREFERRED STOCKS
REAL ESTATE INVESTMENT TRUST -- 2.0%
Crown American Realty Trust............................................. 39,000 $ 1,951,792 $ 1,906,125
New Plan Excel Realty Trust, Cvt........................................ 200,000 5,000,000 5,693,750
Prime Retail, Inc., Cvt. (Series B)..................................... 40,000 701,776 665,000
-------------- --------------
$ 7,653,568 $ 8,264,875
-------------- --------------
CONVERTIBLE BONDS AND DEBENTURES
REAL ESTATE INVESTMENT TRUST -- 2.0%
CenterTrust Retail Properties, Inc.
-- 7 1/2% 2001 (Series A)............................................. $ 1,050,000 $ 916,125 $ 996,844
-- 7 1/2% 2001 (Series B)............................................. 2,750,000 2,459,375 2,557,500
Developers Diversified Realty Corporation -- 7% 1999.................... 2,500,000 2,430,625 2,639,062
Rockefeller Center Properties, Inc. -- 0% 2000.......................... 3,005,000 2,423,515 2,283,800
-------------- --------------
$ 8,229,640 $ 8,477,206
-------------- --------------
PRODUCER DURABLE GOODS -- 1.6%
DRS Technologies, Inc. -- 9% 2003....................................... $ 2,000,000 $ 2,000,000 $ 2,450,000
Lam Research Corporation -- 5% 2002..................................... 2,000,000 1,630,000 1,570,000
Reptron Electronics, Inc. -- 6 3/4% 2004................................ 5,980,000 5,798,575 2,840,500
-------------- --------------
$ 9,428,575 $ 6,860,500
-------------- --------------
HEALTH CARE -- 1.4%
IVAX Corporation -- 6 1/2% 2001......................................... $ 1,500,000 $ 1,256,125 $ 1,436,250
NovaCare, Inc. -- 5 1/2% 2000........................................... 5,250,000 4,809,375 4,245,938
-------------- --------------
$ 6,065,500 $ 5,682,188
-------------- --------------
BUSINESS SERVICES & SUPPLIES -- 1.2%
World Access, Inc. -- 4 1/2% 2002....................................... $ 6,005,000 $ 4,756,894 $ 5,029,187
-------------- --------------
TRANSPORTATION -- 0.6%
Offshore Logistics, Inc. -- 6% 2003..................................... $ 2,500,000 $ 2,157,501 $ 2,162,500
Reno Air Inc. -- 9% 2002................................................ 370,000 384,800 387,575
-------------- --------------
$ 2,542,301 $ 2,550,075
-------------- --------------
ENERGY -- 0.2%
Remington Oil & Gas Corporation -- 8 1/4% 2002.......................... $ 1,000,000 $ 972,500 $ 985,000
-------------- --------------
TECHNOLOGY -- 0.2%
Read-Rite Corporation -- 6 1/2% 2004.................................... $ 1,000,000 $ 808,750 $ 735,000
-------------- --------------
CONSUMER NON-DURABLE GOODS -- 0.1%
Bell Sports Corp. -- 4 1/4% 2000........................................ $ 385,000 $ 338,756 $ 311,850
-------------- --------------
TOTAL CONVERTIBLE BONDS AND DEBENTURES -- 7.3%.......................... $ 33,142,916 $ 30,631,006
-------------- --------------
</TABLE>
7
<PAGE>
PORTFOLIO OF INVESTMENTS
December 31, 1998
<TABLE>
<CAPTION>
NON-CONVERTIBLE BONDS AND DEBENTURES Face Amount Cost Value
- ------------------------------------------------------------------------ ----------- -------------- --------------
<S> <C> <C> <C>
CORPORATE -- 3.7%
Advantica Restaurant Group, Inc. -- 11 1/4% 2008........................ $ 2,131,100 $ 2,161,875 $ 2,147,083
DLJ Mortgage Acceptance Corp. (Series 1997-E Class B)
-- 7.5481% 2026+....................................................... 986,900 870,909 796,305
Merrill Lynch Mortgage Investors, Inc. (Series 1992-B)
-- 8.3% 2012........................................................... 284,300 288,923 284,478
Plantronics, Inc. -- 10% 2001........................................... 8,470,000 8,611,244 8,724,100
Trump Atlantic City Associates -- 11 1/4% 2006.......................... 4,000,000 3,925,000 3,500,000
-------------- --------------
$ 15,857,951 $ 15,451,966
-------------- --------------
U.S. GOVERNMENT AND AGENCIES -- 0.6%
Federal Home Loan Mortgage Corporation
-- 6 1/2% 2023 (IO)................................................... $ 2,774,700 $ 334,065 $ 347,705
-- 10.15% 2006 (REMIC)................................................ 127,000 125,953 129,143
Federal National Mortgage Association
-- 7% 2008 (REMIC).................................................... 397,000 394,541 397,248
Government National Mortgage Association (Mobile Home)
-- 9 3/4% 2006........................................................ 186,800 198,267 196,023
-- 9 3/4% 2010........................................................ 1,155,500 1,223,611 1,212,553
-- 10 1/4% 2001-2004.................................................. 256,000 273,182 269,280
-------------- --------------
$ 2,549,619 $ 2,551,952
-------------- --------------
TOTAL NON-CONVERTIBLE BONDS
AND DEBENTURES -- 4.3%................................................ $ 18,407,570 $ 18,003,918
-------------- --------------
TOTAL INVESTMENT SECURITIES -- 97.0%.................................... $ 317,183,569 $ 405,167,116
-------------- --------------
--------------
SHORT-TERM INVESTMENTS -- 2.1%
Short-term Corporate Notes:
Ford Motor Credit Company -- 5.38% 1/5/99............................. $ 5,000,000 $ 4,997,011
General Electric Capital Corporation -- 5 1/2% 1/26/99................ 3,500,000 3,486,632
State Street Bank Repurchase Agreement -- 4% 1/4/99
(Collateralized by U.S. Treasury Bonds -- 7 1/2% 2016,
market value $397,800)................................................. 389,000 389,043
--------------
$ 8,872,686
--------------
TOTAL INVESTMENTS -- 99.1%.............................................. $ 414,039,802
Other assets less liabilities -- 0.9%................................... 3,736,745
--------------
TOTAL NET ASSETS -- 100%................................................ $ 417,776,547
--------------
--------------
</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.
++ Affiliate as defined in the Investment Company Act of 1940 by reason of
ownership of 5% or more of its outstanding voting securities. Following is a
summary of transactions in securities of these affiliates during the year
ended December 31, 1998.
<TABLE>
<CAPTION>
Purchases Sales Realized Dividend
at Cost at Cost Gain Income
------------ ---------- ---------- ----------
<S> <C> <C> <C> <C>
Denison International plc (ADR)................................... $ 3,918,187 -- -- --
Holophane Corporation............................................. -- -- -- --
</TABLE>
See notes to financial statements.
8
<PAGE>
STATISTICAL PROFILE
(UNAUDITED)
PRINCIPAL COMMON STOCK HOLDINGS
<TABLE>
<CAPTION>
Fundamental Data
------------------------------------------------------
10 Year Record* Profitability Valuation Data
----------------- Total ------------------------- --------------------------
Growth Yrs. EPS Debt % Ret. on Ret. on P/E Price/Book Div.
Rate Declined Capital Beg. Equity Avg. Assets Ratio Value Yield
<S> <C> <C> <C> <C> <C> <C> <C> <C>
- ----------------------------------------------------------------------------------------------------------------------------------
Adobe Systems 14% 1 0% 16% 14% 24.7x 5.8x 0.4%
Allergan 6 2 26 16 10 32.1 6.3 0.9
Applied Graphics Technologies ** ** 35 11 5 15.9 0.9 0.0
Arrow Electronics 25 3 43 13 5 15.7 1.8 0.0
Bacou USA ** ** 48 19 11 15.6 2.9 0.0
Belden 9 2 43 18 8 13.3 2.4 0.9
Black Box 27 0 5 28 18 19.2 4.3 0.0
Caraustar 11 4 51 24 9 14.0 3.1 2.5
Carnival 15 0 26 23 14 34.3 7.0 0.8
Channell Commercial 34 0 16 19 12 9.2 1.5 0.0
Circuit City 7 2 31 7 3 42.0 2.9 0.3
Crane 12 1 39 26 10 15.1 3.2 1.3
Denison International (ADR) ** ** 0 26 14 8.7 1.9 0.0
DENTSPLY International ** ** 34 19 10 17.2 3.2 0.9
Donaldson 15 0 30 23 12 18.0 4.0 1.2
Expeditors International 19 0 11 28 12 24.4 5.5 0.3
Federal Signal 12 1 52 20 8 20.9 4.0 2.6
Galileo International 26 0 7 30 16 22.5 5.4 0.7
Graco 14 2 102 33 19 14.4 5.4 1.5
Holophane ** ** 24 27 14 15.4 3.6 0.0
HON INDUSTRIES 17 2 22 28 13 13.9 3.2 1.3
IDEX 14 1 50 23 9 13.3 2.6 2.3
JLK Direct Distribution (Cl. A) ** ** 8 11 9 11.4 1.3 0.0
Kaydon 14 1 0 25 18 18.5 4.2 1.0
KEMET 0 1 35 6 3 24.5 1.4 0.0
Lancaster Colony 16 0 11 25 18 14.4 3.3 1.9
Landauer 7 0 0 48 28 21.9 9.8 4.3
Manpower 21 0 29 22 4 15.4 2.9 0.8
Methode Electronics (Cl. A) 18 2 0 15 12 17.0 2.4 1.3
Nucor 15 3 10 15 9 13.6 1.9 1.1
Office Depot 35 1 24 15 7 30.3 4.1 0.0
OM Group 16 0 44 16 7 17.7 2.2 1.0
O'Reilly Automotive 21 0 45 15 8 37.8 5.0 0.0
Poe & Brown 11 2 10 29 11 20.2 6.1 1.3
Schlumberger 12 3 33 19 10 18.5 3.2 1.6
Wells Fargo ** ** 64 17 2 19.2 3.2 1.9
- ----------------------------------------------------------------------------------------------------------------------------------
Source Portfolio 12 1 32 19 9 17.6 3.0 0.9
Russell 2500 9 ** 41 15 6 25.0 2.7 1.4
S&P Industrials 8 2 51 19 6 31.4 5.9 1.2
- ----------------------------------------------------------------------------------------------------------------------------------
* 5 to 9 year data used when 10 years not available
**Comparable data not available
</TABLE>
9
<PAGE>
MAJOR PORTFOLIO CHANGES
(UNAUDITED)
Quarter Ended December 31, 1998
<TABLE>
<CAPTION>
Shares or
Face Amount
----------------
<S> <C>
NET PURCHASES
COMMON STOCKS
Applied Graphics Technologies, Inc.......................................................................... 627,200 shs.
Belden Inc.................................................................................................. 42,400 shs.
Crane Co.(1)................................................................................................ 175,600 shs.
Galileo International, Inc.................................................................................. 26,500 shs.
Graco Inc................................................................................................... 23,500 shs.
HON INDUSTRIES Inc.(1)...................................................................................... 566,600 shs.
JLK Direct Distribution Inc. (Class A)...................................................................... 44,400 shs.
OM Group, Inc............................................................................................... 11,600 shs.
CONVERTIBLE SECURITIES
Remington Oil & Gas Corporation -- 8 1/4% 2002(1)........................................................... $ 1,000,000
World Access, Inc. -- 4 1/2% 2002(1)........................................................................ $ 6,005,000
NET SALES
COMMON STOCKS
Allergan, Inc............................................................................................... 42,200 shs.
Caraustar Industries, Inc................................................................................... 25,000 shs.
Carnival Corporation........................................................................................ 172,200 shs.
Cooper Tire & Rubber Company(2)............................................................................. 532,600 shs.
Leggett & Platt, Incorporated(2)............................................................................ 145,400 shs.
O'Reilly Automotive, Inc.................................................................................... 10,000 shs.
Progressive Corporation, The(2)............................................................................. 37,800 shs.
Wells Fargo & Company....................................................................................... 97,000 shs.
NON-CONVERTIBLE SECURITIES
Busse Broadcasting Corporation -- 11 5/8% 2000(2)........................................................... $ 2,350,000
Federal Home Loan Mortgage Corporation -- 7% 2023 (CMO)(2).................................................. $ 2,203,400
GPA Delaware Inc. -- 8 3/4% 1998(2)......................................................................... $ 2,000,000
</TABLE>
(1) Indicates new commitment to portfolio
(2) Indicates elimination from portfolio
10
<PAGE>
FEDERAL INCOME TAX INFORMATION
(UNAUDITED)
CALENDAR 1998
CASH DIVIDENDS AND DISTRIBUTIONS:
<TABLE>
<CAPTION>
(1) (2)
ORDINARY LONG-TERM
AMOUNT PAID INCOME CAPITAL GAIN
DATE PAID PER SHARE DIVIDENDS DISTRIBUTIONS
- -------------------------------------------------------- ----------- ----------- -------------
<S> <C> <C> <C>
PREFERRED STOCK:
03/15/98 $ 0.60 $ 0.60 --
06/15/98 0.60 0.60 --
09/15/98 0.60 0.60 --
12/15/98 0.60 0.60 --
----- ----------- ------
TOTAL $ 2.40 $ 2.40 --
----- ----------- ------
----- ----------- ------
COMMON STOCK:
03/15/98 $ 1.00 $ 0.989 $ 0.011
06/15/98 1.05 -- 1.050
09/15/98 1.05 -- 1.050
12/15/98 1.05 -- 1.050
12/15/98 (special year-end) 0.47 -- 0.470
----- ----------- ------
TOTAL $ 4.62 $ 0.989 $ 3.631
----- ----------- ------
----- ----------- ------
</TABLE>
The amount in column (1) is to be included as dividend income on your tax
return. For corporate shareholders, 32.9% of the amount in column (1) qualifies
for the 70% corporate dividends received deduction.
In accordance with the provisions of the Internal Revenue Code, the amounts in
column (2) are long-term capital gain distributions and all amounts qualify as
20% rate gain distributions.
A Form 1099 has been mailed to all shareholders of record on dividend record
dates setting forth the specific amounts to be included in their 1998 tax
returns. Source Capital had no undistributed long-term capital gains at
year-end. Therefore, Common shareholders will not receive a Form 2439 for 1998.
- --------------------------------------------------------------------------------
NOTICE TO DIVIDEND REINVESTMENT PLAN PARTICIPANTS:
The information above shows the cash distributions paid by Source Capital
during 1998. When additional shares are issued by Source Capital under the
Automatic Reinvestment Plan at a discount from the market price, a participant
in the Plan is treated for federal income tax purposes as having received a
taxable distribution equal to the market value of the shares purchased. In
effect, the discount from market price at which shares are purchased is added to
the amount of the cash distribution to determine the total value of the taxable
distribution. Such value also becomes the participant's tax basis for the shares
purchased under the Plan.
The distributions paid during the year were reinvested at a discount from the
market price and the additional taxable amount of these distributions for each
Common share purchased is as follows: March 15, 1998, $2.043 per share; June 15,
1998, $1.773 per share; September 15, 1998, $2.250 per share; December 15, 1998,
$2.406 per share.
11
<PAGE>
STATEMENT OF ASSETS AND LIABILITIES
<TABLE>
<CAPTION>
December 31, 1998
------------------------------
<S> <C> <C>
ASSETS
Investments at value:
Investment securities -- at market value
(cost $317,183,569) -- Note A.......................................................... $ 405,167,116
Short-term investments -- at cost plus interest earned
(maturities 60 days or less) -- Note A................................................. 8,872,686 $ 414,039,802
--------------
Cash....................................................................................... 774
Receivable for:
Investment securities sold............................................................... $ 2,464,726
Dividends and accrued interest........................................................... 1,762,165 4,226,891
-------------- --------------
$ 418,267,467
LIABILITIES
Payable for:
Advisory fees............................................................................ $ 241,385
Accrued dividends -- Preferred Stock..................................................... 196,921
Accrued expenses......................................................................... 52,614 490,920
-------------- --------------
TOTAL NET ASSETS -- December 31, 1998........................................................ $ 417,776,547
--------------
--------------
Assets applicable to Preferred Stock at a liquidation preference of
$27.50 per share (asset coverage 771%) -- Note B......................................... $ 54,153,330
--------------
--------------
Net assets applicable to Common Stock -- $48.23 per share.................................. $ 363,623,217
--------------
--------------
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 7,540,060 shares -- Note B................................................... 7,540,060
Additional Paid-in Capital................................................................. 303,964,037
Undistributed net investment income........................................................ 3,073,051
Undistributed net realized gain on investments............................................. 9,308,216
Unrealized appreciation of investments..................................................... 87,983,547
--------------
TOTAL NET ASSETS -- December 31, 1998........................................................ $ 417,776,547
--------------
--------------
</TABLE>
See notes to financial statements.
12
<PAGE>
STATEMENT OF OPERATIONS
<TABLE>
<S> <C> <C> <C> <C>
For the year ended December 31,
-----------------------------------------------------
1998 1997
-------------------------- -------------------------
INVESTMENT INCOME
Income:
Interest........................................... $ 6,087,760 $ 7,319,925
Dividends.......................................... 4,145,775 4,213,053
------------ -----------
$ 10,233,535 $11,532,978
Expenses -- Note C:
Advisory fees...................................... $ 2,886,224 $ 2,836,701
Transfer agent fees and expenses................... 276,110 239,812
Reports to shareholders............................ 181,622 218,100
Directors' fees and expenses....................... 79,000 80,320
Custodian fees and expenses........................ 47,675 48,613
Taxes, other than federal income tax............... 65,800 65,840
Legal and auditing fees............................ 39,504 38,285
Registration and filing fees....................... 16,758 16,330
Other expenses..................................... 23,209 3,615,902 30,458 3,574,459
------------ ------------ ------------ -----------
Net investment income -- Note A................ $ 6,617,633 $ 7,958,519
------------ -----------
NET REALIZED AND UNREALIZED GAIN
ON INVESTMENTS
Net realized gain on investments:
Proceeds from sale of investment securities
(excluding short-term corporate notes with
maturities 60 days or less)...................... $135,720,589 $124,684,468
Cost of investment securities sold................. 100,213,660 81,799,856
------------ ------------
Net realized gain on investments -- Notes A and
D.............................................. $ 35,506,929 $42,884,612
Unrealized appreciation of investments:
Unrealized appreciation at beginning of year....... $105,473,310 $ 71,695,457
Unrealized appreciation at end of year............. 87,983,547 105,473,310
------------ ------------
Increase (decrease) in unrealized appreciation of
investments.................................... (17,489,763) 33,777,853
------------ -----------
Net realized and unrealized gain on
investments.................................. $ 18,017,166 $76,662,465
------------ -----------
NET INCREASE IN TOTAL NET
ASSETS RESULTING FROM OPERATIONS..................... $ 24,634,799 $84,620,984
------------ -----------
------------ -----------
</TABLE>
See notes to financial statements.
13
<PAGE>
STATEMENT OF CHANGES IN TOTAL NET ASSETS
<TABLE>
<CAPTION>
For the year ended December 31,
------------------------------------------------------
1998 1997
-------------------------- --------------------------
<S> <C> <C> <C> <C>
INCREASE (DECREASE) IN TOTAL NET ASSETS
Operations:
Net investment income................. $ 6,617,633 $ 7,958,519
Net realized gain on investments
-- Notes A and D.................... 35,506,929 42,884,612
Increase (decrease) in unrealized
appreciation of investments......... (17,489,763) 33,777,853
------------ ------------
Increase in total net assets resulting
from operations....................... $ 24,634,799 $ 84,620,984
Distributions to Preferred shareholders:
From net investment income............ (4,726,109) (4,726,109)
Distributions to Common shareholders:
From net investment income............ $ (3,043,180) $ (2,329,594)
From net realized capital gains....... (31,365,719) (34,408,899) (42,080,024) (44,409,618)
------------ ------------
Proceeds from shares issued for
distributions reinvested by
shareholders -- Note B................ 6,786,649 7,858,423
------------ ------------
Increase (decrease) in total net
assets................................ $ (7,713,560) $ 43,343,680
TOTAL NET ASSETS
Beginning of year, including
undistributed net investment income
of $4,224,707 and $3,321,891.......... 425,490,107 382,146,427
------------ ------------
End of year, including
undistributed net investment income
of $3,073,051 and $4,224,707.......... $417,776,547 $425,490,107
------------ ------------
------------ ------------
</TABLE>
See notes to financial statements.
- --------------------------------------------------------------------------------
NOTICE OF SOURCE OF DISTRIBUTIONS
(Common Stock Only)
Since the sources from which distributions are paid cannot be determined
until the end of each fiscal year, the following information amends the
statements forwarded to Common shareholders with each distribution.
<TABLE>
<CAPTION>
Source of Distributions
--------------------------
<S> <C> <C> <C>
Amount Net
Paid Investment Net Realized
Date Paid Per Share Income Capital Gains
- -------------------------- --------- ---------- -------------
3/15/98 $1.00 $0.411 $0.589
6/15/98 1.05 -- 1.050
9/15/98 1.05 -- 1.050
12/15/98 1.05 -- 1.050
12/15/98(special) 0.47 -- 0.470
--------- ---------- ------
$4.62 $0.411 $4.209
--------- ---------- ------
--------- ---------- ------
</TABLE>
The source of distributions for financial reporting purposes differs from
federal income tax reporting. See page 11 for federal income tax information.
14
<PAGE>
FINANCIAL HIGHLIGHTS
Selected data for a share of Common Stock outstanding throughout each year
<TABLE>
<CAPTION>
Year ended December 31,
-----------------------------------------------------
1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Per share operating performance:
Net asset value at beginning of year..................................... $ 50.20 $ 45.35 $ 42.58 $ 38.52 $ 41.85
--------- --------- --------- --------- ---------
Net investment income.................................................... $ 0.88 $ 1.08 $ 1.30 $ 1.48 $ 1.62
Net realized and unrealized gain (loss)
on investment securities............................................... 2.37 10.50 8.25 6.84 (0.67)
--------- --------- --------- --------- ---------
Total from investment operations....................................... $ 3.25 $ 11.58 $ 9.55 $ 8.32 $ 0.95
--------- --------- --------- --------- ---------
Distributions to Preferred shareholders:
From net investment income............................................. $ (0.63) $ (0.65) $ (0.65) $ (0.66) $ (0.69)
Distributions to Common shareholders:
From net investment income............................................. (0.41) (0.32) (0.51) (0.50) (1.14)
From net realized gains................................................ (4.21) (5.76) (5.62) (3.10) (2.03)
In excess of net realized gains........................................ -- -- -- -- (0.02)
From Additional Paid-in Capital........................................ -- -- -- -- (0.41)
--------- --------- --------- --------- ---------
Total distributions.................................................. $ (5.25) $ (6.73) $ (6.78) $ (4.26) $ (4.29)
--------- --------- --------- --------- ---------
Effect of shares issued for distributions
reinvested by shareholders............................................. $ 0.03 -- -- -- $ 0.01
--------- --------- --------- --------- ---------
Net asset value at end of year........................................... $ 48.23 $ 50.20 $ 45.35 $ 42.58 $ 38.52
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Per share market value at end of year.................................... $ 49.06 $ 51.06 $ 45.50 $ 41.88 $ 37.00
Total investment return(1)............................................... 5.8% 26.9% 24.5% 23.4% (6.5)%
Net asset value total return(2).......................................... 5.8% 25.4% 21.9% 20.7% 0.6%
Ratios/supplemental data:
Net assets at end of year (in thousands)............................... $417,777 $425,490 $382,146 $362,087 $329,427
Ratio of expenses to average net assets................................ 0.87% 0.87% 0.89% 0.91% 0.96%
Ratio of net income to average net assets.............................. 1.59% 1.95% 2.52% 3.04% 3.36%
Portfolio turnover rate................................................ 28.34% 27.46% 41.04% 51.44% 71.39%
Preferred Stock:
Total shares outstanding(3).............................................. 1,969,212 1,969,212 1,969,212 1,969,212 1,969,212
Asset coverage per share(3).............................................. $212.15 $216.07 $194.06 $183.87 $167.29
Involuntary liquidation preference per share............................. $27.50 $27.50 $27.50 $27.50 $27.50
Average market value per share(4)........................................ $29.95 $28.72 $28.50 $28.00 $27.89
</TABLE>
(1) Based on market value per share, adjusted for reinvestment of distributions
(2) Based on net asset value per share, adjusted for reinvestment of
distributions
(3) Information shown as of the end of the year
(4) The average of all month-end market values during each year
See notes to financial statements.
- --------------------------------------------------------------------------------
QUARTERLY RESULTS OF INVESTMENT OPERATIONS (unaudited)
<TABLE>
<CAPTION>
Quarter ended
-----------------------------------------------------
March 31, June 30, September 30, December
1998 1998 1998 31, 1998
----------- ----------- ------------- -----------
<S> <C> <C> <C> <C>
Total investment income...................... $ 2,980,555 $ 2,692,244 $ 2,297,189 $2,263,547
Net investment income........................ $ 2,008,371 $ 1,707,018 $ 1,481,974 $1,420,270
Income available to Common................... $ 826,844 $ 515,491 $ 300,446 $ 238,743
Per share Common........................... $0.11 $0.07 $0.04 $0.03
Net realized and unrealized
appreciation (depreciation)................ $33,352,971 $(5,124,829) $(77,006,794) $66,795,818
Per share Common........................... $4.51 $(0.70) $(10.33) $8.89
<CAPTION>
Quarter ended
-----------------------------------------------------
March 31, June 30, September 30, December
1997 1997 1997 31, 1997
----------- ----------- ------------- -----------
<S> <C> <C> <C> <C>
Total investment income...................... $ 2,832,137 $ 2,872,391 $ 2,974,098 $2,854,352
Net investment income........................ $ 1,976,386 $ 1,967,579 $ 2,050,153 $1,964,401
Income available to Common................... $ 794,859 $ 786,052 $ 868,625 $ 782,874
Per share Common........................... $0.11 $0.11 $0.12 $0.09
Net realized and unrealized
appreciation (depreciation)................ $(3,801,363) $43,673,202 $ 34,116,727 $2,673,899
Per share Common........................... $(0.52) $5.98 $4.67 $0.37
</TABLE>
15
<PAGE>
NOTES TO FINANCIAL STATEMENTS
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
NASDAQ National Market System are valued at the last sale price on the last
business day of the year, 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
corporate notes with maturities of 60 days or less are valued at cost plus
interest earned, which approximates market value. 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 on net investment
income 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. 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.
4. OTHER--Securities transactions are accounted for on the date the
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. The ratios of expenses and net income to average net assets do not reflect
the effect of dividend payments to Preferred shareholders.
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.
During the years ended December 31, 1998 and 1997, the Company issued
142,801 and 165,149 shares of Common Stock, respectively, under its Reinvestment
Plan for Common and Preferred shareholders.
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 years ended December 31, 1998 and 1997, the Company paid aggregate
fees of $79,000 and $80,000, respectively, to all Directors who are not
affiliated persons of the Investment Adviser. During the years ended December
31, 1998 and 1997, the Company incurred legal fees of $7,180 and $5,960,
respectively, 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.
NOTE D--PURCHASES AND SALES OF SECURITIES
The cost of purchases of investment securities (excluding short-term
corporate notes with maturities of 60 days or less) aggregated $112,593,877 and
$104,354,394 for the years ended December 31, 1998 and 1997, respectively.
Realized gains and losses are based on the specific-certificate identification
method. The cost of investment securities owned at December 31, 1998 was the
same for federal income tax and financial reporting purposes.
NOTE E--YEAR 2000 (UNAUDITED)
Like other investment companies, financial and business organizations
around the world, the Company could be adversely affected if the computer
systems used by the Adviser and its other major 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 Issue." The Adviser
has assessed its computer systems and the systems compliance issues of the
Company's major service providers. The Adviser is taking steps that it believes
are reasonably designed to address the Year 2000 Issue with respect to the
computer systems it uses and has obtained satisfactory assurances that
comparable steps are being taken by the Company's major service providers. At
this time, however, there can be no assurance that these steps will be
sufficient to address all Year 2000 Issues. The inability of the Adviser or the
Company's other third party providers to timely complete all necessary
procedures to address the Year 2000 Issue could have a material adverse effect
on the Company's operations. The Adviser will continue to monitor the status of,
and the Company's exposure to, this issue. For the year ended December 31, 1998,
the Company incurred no significant Year 2000 related expenses and it does not
expect to incur significant Year 2000 expenses in the future. The Adviser is in
the process of establishing a contingency plan to address recovery from
unavoided or unavoidable Year 2000 problems, if any, affecting the Company.
NOTE F--QUARTERLY INFORMATION
See page 15 for unaudited quarterly results of investment operations.
16
<PAGE>
REPORT OF INDEPENDENT AUDITORS
TO THE BOARD OF DIRECTORS AND
SHAREHOLDERS OF SOURCE CAPITAL, INC.
We have audited the accompanying statement of assets and liabilities of
Source Capital, Inc. (the "Company"), including the portfolio of investments, as
of December 31, 1998, the related statements of operations and changes in total
net assets for each of the two years in the period then ended, and the financial
highlights for each of the five years in the period then ended. These financial
statements and financial highlights are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and financial
highlights are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements and financial highlights. Our procedures included confirmation of
securities owned as of December 31, 1998, by correspondence with the custodian
and brokers. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of Source
Capital, Inc. as of December 31, 1998, the results of its operations and the
changes in its total net assets for each of the two years in the period then
ended, and the financial highlights for each of the five years in the period
then ended, in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Los Angeles, California
January 22, 1999
17
<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>
