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[LOGO]
SOURCE CAPITAL, INC.
FIRST QUARTER REPORT
March 31, 1999
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OFFICERS AND DIRECTORS
[LOGO]
SOURCE CAPITAL, INC.
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
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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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
INVESTMENT RESULTS
Source Capital's total net assets decreased to $379,184,516 from $417,776,547
at year-end. Net asset value per Common share decreased to $42.91 at March 31,
1999 from $48.23 at year-end. In addition, a distribution of $1.05 was paid on
the Common shares during the quarter.
During this quarter, Source Capital's net asset value per share of Common Stock
decreased 8.8% while total net assets declined 7.4%, with both figures
reflecting reinvestment of dividends and distributions paid during the period.
These changes compare with a 4.7% decrease during the quarter for the Russell
2500 Index, also on a reinvested basis.
NET INVESTMENT INCOME
Net investment income decreased during the quarter to $1,193,353 from
$2,008,371 in the first quarter of 1998. After providing for Preferred
dividends, net investment income per Common share amounted to less than $0.01
compared with $0.11 in the prior year. As has been the case for the past several
years, net investment income has continued to decline as the asset allocation to
equities has increased.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $1.05 per share was paid on
March 15, 1999 to shareholders of record on February 26, 1999. Source's 10%
Distribution Policy, adopted in 1976, calls for payments to Common shareholders
approximating 10% of the Common Stock's ongoing net asset value. Shareholders
are reminded that these payments substantially exceed the Company's net
investment income and thus represent a continuing payment of a portion of the
Company's capital. As we repeatedly point out, maintenance of the current $4.20
Common distribution rate is dependent upon achieving total investment results
which will sustain a net asset value of approximately $42.00.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on March 15, 1999 to
shareholders of record on February 26, 1999. The decrease in the Company's total
net assets so far this year has led to a decrease in the Preferred shares' asset
coverage from 771% at year-end 1998 to 700% at March 31, 1999. The decline in
net investment income in the first quarter decreased Preferred dividend coverage
to 101% compared to 170% in the first quarter of 1998.
MARKET PRICE OF SOURCE CAPITAL SHARES
The market price of Source Capital Common Stock decreased during the quarter
from $49 1/16 at year-end 1998 to $45 11/16 at March 31, 1999. As this $3.375
decrease in market price was less than the $5.32 decline in net asset value
during the period, the market premium to net asset value of 1.7% at year-end
1998 increased to 6.5% at March 31, 1999. The market price of Source Capital
Preferred Stock also decreased during the quarter from $29 13/16 to $28 1/2.
COMMENTARY
The first quarter of 1999 brought a continuation of the stock market trends we
experienced during 1998. The market leaders continued to be a tiny group of very
large, very high PE companies, mostly in technology businesses. Because these
companies so dominate the performance of the capitalization weighted S&P 500 and
Nasdaq indexes, it is easy to get the
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impression that the stock market has been rising over the past 15 months. This
is not the case. The average stock was down in 1998, and did even worse in
1999's first quarter.
The contrast in performance is readily illustrated in the following table,
which compares the big-cap dominated S&P 500 and Nasdaq indexes with the
broadly-based Russell 2000 and 2500.
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<CAPTION>
1999
1998 FIRST QUARTER
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<S> <C> <C>
Nasdaq +39.6% +12.3%
S&P 500 +28.6% +5.0%
Russell 2500 +0.4% (4.7)%
Russell 2000 (2.6)% (5.4)%
</TABLE>
It is worth noting that an extrapolation of the first quarter's performance for
the rest of 1999 would result in a full year with big cap - small cap
performance discrepancies even greater than the extremes of 1998!
As was the case in 1998, the leadership of even these big-cap averages was very
narrow. The ten largest S&P 500 companies, which account for 20% of the S&P's
market cap, were up 7% in the first quarter, following their 38% gain in 1998.
The ten largest Nasdaq companies, which account for 40% of the index's market
cap, gained 23% in the first quarter, after a stunning 115% rise in 1998.
We are referring to the Nasdaq as well as the S&P 500 because it epitomizes the
market trends of recent years. It is highly concentrated, its largest companies
are nearly all in technology businesses, and it is lead by the "Four Horsemen"
- -- Microsoft, Intel, Cisco, and Dell. I find it intriguing that the market cap
of these four companies, about $900 billion, is roughly equal to that of ALL of
the Russell 2000 companies combined. If we used revenues as our yardstick,
however, the Russell 2000 companies would be roughly 15 times as large as these
four firms.
Source Capital's investment performance during the first quarter was
disappointing, with a decline of about 9% compared to the 5% decline in the
Russell 2500 Index. This was more the result of many of our holdings being out
of favor, rather than a reflection of fundamental problems in the businesses of
companies in the portfolio.
We are pleased to note that market performance during April and early May has
been much more to our liking -- small stocks have outperformed big ones and
undervalued low-PE companies have outperformed overvalued high-PE ones, etc.
Whether this represents a sea change, or is merely a rogue wave, remains to be
seen.
OCULAR SCIENCES, a manufacturer of contact lenses, was recently added to the
Source portfolio.
There are a number of well-known brands in the contact lens business, including
Johnson & Johnson's Acuvue, Bausch & Lomb, and Ciba. Notably absent from this
list is Ocular Sciences. This is because the widely recognized names listed
above have made a substantial investment in marketing to consumers. Ocular
Sciences, in contrast, markets only to eye care professionals -- doctors and
optical chains.
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Eye doctors are looking primarily for two things from their contact lens
suppliers -- a high quality product for their patients, and an opportunity to
earn a good profit for themselves.
Ocular Sciences provides what the eye doctors want. They make high quality
contacts which many patients find more comfortable to wear and easier to insert,
and the eye doctors can earn more from prescribing Ocular Sciences' contacts
than from those of other optical companies.
To understand why this is so, we must realize that eye doctors earn only about
one-third of their revenues from professional services like eye exams. The
remaining two-thirds come from selling products such as eyeglasses or contact
lenses. Therefore, it is extremely important for the eye doctors' financial
health whether or not their patients who wear disposable contact lenses return
to the doctors to periodically refill their contact lens prescriptions.
Ocular Sciences encourages the patients to do so by providing the doctors with
unique or semi-exclusive brands subject to less price comparison and by not
selling its products through alternative distribution channels -- drug stores,
mail order, internet retailers.
In addition to providing compelling reasons for eye care professionals to
prescribe its products, Ocular Sciences' business model also has a lower cost
structure than those of its competitors. It avoids the heavy expense of consumer
advertising, and it uses an efficient telemarketing sales force instead of the
costly direct sales force that the others employ.
As a result of Ocular's superior business model, it is steadily gaining market
share (now #2 behind J & J in the key U.S. weekly disposable market), it earns
big operating margins and returns on capital, and its sales and profits have
grown rapidly. In addition, its balance sheet has no debt and $2 per share in
cash.
We were able to purchase Ocular Sciences this February at an average price of
$21 per share, about 16X last year's $1.30 per share earnings, because of the
stock market's concern about J & J price cutting (J & J had cut contact lens
prices last summer in an unsuccessful attempt to stem Ocular's market share
gains), and expectations of flat first quarter earnings for Ocular. Subsequent
to our purchase, Ocular reported an excellent first quarter, and fears of
another price reduction by J & J subsided, as they switched their emphasis to
introducing new products. Analysts raised their estimates for Ocular's 1999
earnings and the price rose above $30 per share -- still a modest valuation for
a company with Ocular's high return on capital, rapid growth in sales and
earnings, and unique business model.
Ocular is an excellent example of Source's investment process, which focuses on
purchasing high return, unleveraged businesses at reasonable prices, and
allowing the successful operation of the business to generate returns over time.
Respectfully submitted,
[/S/ ERIC S. ENDE]
Eric S. Ende
Senior Vice President and
Chief Investment Officer
May 10, 1999
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MAJOR PORTFOLIO CHANGES
Quarter Ended March 31, 1999
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<CAPTION>
Shares or
Principal Ownership at
Amount March 31, 1999
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<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Bacou USA, Inc.................................... 116,700 shs. 448,100 shs.
Black Box Corporation............................. 23,500 shs. 404,400 shs.
Crane Co.......................................... 134,400 shs. 310,000 shs.
Graco Inc......................................... 122,000 shs. 556,500 shs.
HON INDUSTRIES Inc................................ 26,400 shs. 593,000 shs.
IDEX Corporation.................................. 89,900 shs. 518,400 shs.
Ocular Sciences, Inc.............................. 222,800 shs. 222,800 shs.
OM Group, Inc..................................... 39,900 shs. 342,500 shs.
Romac International Inc........................... 359,300 shs. 359,300 shs.
Zebra Technologies Corporation (Class A).......... 269,900 shs. 269,900 shs.
CONVERTIBLE SECURITIES
Central Garden & Pet Co. -- 6% 2003............... $1,000,000 $1,000,000
Offshore Logistics, Inc. -- 6% 2003............... $3,000,000 $5,500,000
NON-CONVERTIBLE SECURITY
Pathmark Stores, Inc. -- 12 5/8% 2002............. $3,000,000 $3,000,000
NET SALES
COMMON STOCKS
Adobe Systems Incorporated........................ 16,500 shs. 301,000 shs.
Allergan, Inc..................................... 105,800 shs. --0--
Caraustar Industries, Inc......................... 12,000 shs. 400,500 shs.
Circuit City Stores, Inc.......................... 28,000 shs. 195,000 shs.
Expeditors International of Washington, Inc....... 13,800 shs. 133,600 shs.
Galileo International, Inc........................ 96,700 shs. 291,700 shs.
Wells Fargo & Company............................. 125,000 shs. 116,836 shs.
CONVERTIBLE SECURITIES
Remington Oil & Gas
Corporation -- 8 1/4% 2002...................... $1,000,000 --0--
Reno Air Inc. -- 9% 2002.......................... $370,000 --0--
NON-CONVERTIBLE SECURITY
Plantronics, Inc. -- 10% 2001..................... $8,470,000 --0--
</TABLE>
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COMPOSITION OF TOTAL NET ASSETS*
March 31, 1999
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<S> <C>
Investment securities (cost $330,531,124):
Common stocks....................................................... $324,731,078
Convertible bonds, debentures and preferred stocks.................. 37,391,381
Non-convertible bonds and debentures................................ 11,736,638
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$373,859,097
Cash, receivables, short-term corporate notes, less liabilities....... 5,325,419
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Total Net Assets at March 31, 1999.................................... $379,184,516
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Assets applicable to Preferred Stock at a liquidation preference
of $27.50 per share (asset coverage 700%)........................... $ 54,153,330
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Net Assets applicable to Common Stock -- $42.91 per share............. $325,031,186
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SUMMARY FINANCIAL INFORMATION*
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<CAPTION>
Three Months Ended March 31,
1999
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Total Per
Net Common
Assets Share
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<S> <C> <C>
Beginning of period.................................................... $ 417,776,547 $ 48.23
Net realized gain on investments....................................... 12,418,056 1.64
Decrease in unrealized appreciation of investments..................... (44,655,574) (5.92)
Income available to Common shareholders................................ 11,826 --
Quarterly distribution to Common shareholders.......................... (7,917,063) (1.05)
Proceeds from shares issued for distributions reinvested............... 1,550,724 0.01
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Net changes during period.............................................. $ (38,592,031) $ (5.32)
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End of period.......................................................... $ 379,184,516 $ 42.91
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<CAPTION>
Beginning End
of Quarter of Quarter
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<S> <C> <C>
Common market price per share.......................................... 49 1/16 45 11/16
Common market premium to net asset value............................... 1.7% 6.5%
Preferred asset coverage............................................... 771% 700%
Preferred market price per share....................................... 29 13/16 28 1/2
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* THE FINANCIAL INFORMATION INCLUDED IN THIS REPORT HAS BEEN TAKEN FROM THE
RECORDS OF THE COMPANY WITHOUT EXAMINATION BY INDEPENDENT AUDITORS. SECURITIES
ARE CARRIED AT MARKET VALUE.
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SOURCE CAPITAL, INC.
11400 West Olympic Boulevard,
Suite 1200
Los Angeles, California 90064
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