<PAGE> 1
_______________________________________________________________________________
PROSPECTUS
FPA Capital Fund, Inc.
("Fund") seeks long-term
capital growth. Current
income is a factor, but a
secondary consideration.
The Fund's investment
adviser, First Pacific
Advisors, Inc.
("Adviser"), generally
invests the Fund's assets
in common stocks and other
securities which it
believes have the
potential to increase in
market value. Fund shares
are presently offered for
sale only to existing
shareholders and to
directors, officers and
employees of the Fund, the
Adviser, and affiliated
companies.
This Prospectus briefly
outlines information
prospective investors
should know before
purchasing Fund shares.
Investors should read and
retain this Prospectus for
future reference.
A Statement of
Additional Information
about the Fund dated
August 1, 1996, which is
incorporated by reference
in this Prospectus, has
been filed with the
Securities and Exchange
Commission. It is
available at no charge by
contacting FPA Fund
Distributors, Inc.
("Distributor") at 11400
West Olympic Boulevard,
Suite 1200, Los Angeles,
California 90064;
telephone (310)473-0225 or
(800)982-4372, except from
Alaska, Hawaii and Puerto
Rico.
THESE SECURITIES HAVE
NOT BEEN APPROVED OR
DISAPPROVED BY THE
SECURITIES AND EXCHANGE
COMMISSION OR ANY STATE
SECURITIES COMMISSION NOR
HAS THE SECURITIES
AND EXCHANGE COMMISSION OR
ANY STATE SECURITIES
[LOGO] COMMISSION PASSED UPON THE
Distributor: ACCURACY OR ADEQUACY OF THIS
PROSPECTUS. ANY
REPRESENTATION TO THE
CONTRARY IS A CRIMINAL
OFFENSE.
FPA FUND DISTRIBUTORS, INC.
AUGUST 1, 1996
11400 West Olympic Boulevard, Suite 1200
Los Angeles, CA 90064
______________________________________________________________________________
FPA Capital Fund, Inc.
______________________________________________________________________________
<PAGE> 2
FPA CAPITAL FUND, INC.
11400 West Olympic Boulevard, Suite 1200
Los Angeles, California 90064
(310) 473-0225
<TABLE>
<S> <C>
INVESTMENT First Pacific Advisors, Inc.
ADVISER: 11400 West Olympic Boulevard, Suite 1200
Los Angeles, California 90064
DISTRIBUTOR: FPA Fund Distributors, Inc.
11400 West Olympic Boulevard, Suite 1200
Los Angeles, California 90064
(310) 473-0225
(800) 982-4372 except
Alaska, Hawaii and
Puerto Rico
SHAREHOLDER Boston Financial Data
SERVICE AGENT: Services, Inc.
P.O. Box 8500
Boston, Massachusetts 02266-8500
(617) 328-5000
(800) 638-3060 except
Alaska, Hawaii,
Massachusetts and
Puerto Rico
CUSTODIAN AND State Street Bank and
TRANSFER AGENT: Trust Company
225 Franklin Street
Boston, Massachusetts 02110
</TABLE>
INQUIRIES CONCERNING TRANSFER OF REGISTRATION, DISTRIBUTION, REDEMPTIONS AND
SHAREHOLDER SERVICE SHOULD BE DIRECTED TO THE
SHAREHOLDER SERVICE AGENT. INQUIRIES CONCERNING SALES SHOULD BE DIRECTED TO THE
DISTRIBUTOR.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
<S> <C>
Expense Synopsis........................................ 3
Financial Highlights.................................... 4
Investment Objective and Policies....................... 4
The Fund and Its Management............................. 5
Advisory Agreement.................................... 6
FPA Fund Family....................................... 6
Prior Performance Information......................... 7
Purchase of Shares...................................... 7
Net Asset Value....................................... 8
Table of Sales Charges................................ 8
Cumulative Purchase Discount.......................... 8
Letter of Intent...................................... 8
Sales at Net Asset Value.............................. 9
Shareholder Services.................................... 9
FPA Exchange Privilege................................ 9
Money Market Fund Exchange Privilege.................. 10
How to Exchange Shares................................ 10
Investment Account.................................... 10
Pre-Authorized Investment Plan........................ 10
Retirement Plans...................................... 11
Systematic Withdrawal Plan............................ 11
Redemption of Shares.................................... 11
Telephone Transactions................................ 12
Reinvestment Privilege................................ 12
<CAPTION>
PAGE
<S> <C>
Dividends, Distributions and Taxes...................... 12
Dividends............................................. 13
Capital Gains......................................... 13
Taxes................................................. 13
Investment Practices, Risks and Restrictions............ 13
Fixed-Income Securities............................... 13
Mortgage-Backed Securities............................ 13
Lower-Rated Securities and Related Risks.............. 14
Securities of Foreign Issuers......................... 15
Covered Call Options.................................. 15
Short Sales Against the Box........................... 16
Repurchase Agreements................................. 16
Brokerage Practices................................... 16
Portfolio Turnover.................................... 16
Investment Restrictions............................... 16
Other Investment Restrictions......................... 17
Additional Information.................................. 17
Common Stock.......................................... 17
Voting Rights......................................... 17
Shareholder Inquiries................................. 17
Shareholder Service Agent............................. 17
Custodian............................................. 17
Legal Counsel......................................... 17
Independent Auditors.................................. 17
</TABLE>
- --------------------------------------------------------------------------------
No dealer, salesman, or other person has been authorized to give any information
or to make any representations other than those contained in this Prospectus or
in supplemental sales literature distributed by the Distributor in connection
with the offer contained in this Prospectus, and, if given or made, such other
information or representations must not be relied upon as having been authorized
by the Fund or by the Distributor. This Prospectus does not constitute an
offering by the Distributor in any jurisdiction in which such offering may not
lawfully be made.
2
<PAGE> 3
EXPENSE SYNOPSIS
<TABLE>
<S> <C>
SHAREHOLDER TRANSACTION EXPENSES
Maximum Sales Load Imposed on Purchases (as a percentage
of offering price)................................................... 6.50%
Deferred Sales Load (as a percentage of original sales price
or redemption proceeds, as applicable)............................... *
Redemption Fee (as a percentage of amount redeemed).................... None
Exchange Fee........................................................... $5.00
ANNUAL FUND OPERATING EXPENSES
(as a percentage of average net assets)
Management Fees........................................................ 0.65%
12b-1 Fees............................................................. None
Other Expenses (including financial services).......................... 0.22%
-----
Total Fund Operating Expenses..................................... 0.87%
</TABLE>
<TABLE>
<CAPTION>
3 10
1 YEAR YEARS 5 YEARS YEARS
------ ------ ------- -------
<S> <C> <C> <C> <C>
EXAMPLE
You would pay the following expenses on
a $1,000 investment, assuming
(1) five percent annual return and
(2) redemption at the end of each time
period: $73.00 $91.00 $110.00 $165.00
</TABLE>
- ---------------
* An account management fee is charged by unaffiliated investment advisers or
broker-dealers to certain accounts entitled to purchase shares without sales
charge.
The foregoing synopsis is intended to assist the investor in understanding the
various costs and expenses that an investor in the Fund will bear directly or
indirectly. See "Purchase of Shares" and "The Fund and Its Management." The
example is included to provide a means for the investor to compare expense
levels of funds with different fee structures over varying investment periods.
To facilitate such comparison, all funds are required to utilize a five percent
annual return assumption. This assumption is unrelated to the Fund's prior
performance and is not a projection of future performance. THE EXAMPLE SHOULD
NOT BE CONSIDERED A REPRESENTATION OF PAST OR FUTURE EXPENSES. ACTUAL EXPENSES
MAY BE GREATER OR LESSER THAN THOSE SHOWN.
3
<PAGE> 4
FINANCIAL HIGHLIGHTS
The following information has been audited by the Fund's independent auditors.
Their report appears in the Statement of Additional Information. This
information should be read in conjunction with the related financial statements
included in the Statement of Additional Information, which can be obtained
without charge from the Distributor at the address shown on the cover page of
this Prospectus.
For one share outstanding throughout each year
<TABLE>
<CAPTION>
FOR THE YEARS ENDED MARCH 31,
------------------------------------------------------------------------------------------------------
1996 1995 1994 1993 1992 1991 1990 1989 1988 1987
-------- -------- -------- -------- -------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Per share operating
performance:
Net asset value at
beginning
of year................. $ 22.40 $ 19.30 $ 19.06 $ 18.32 $ 14.60 $ 13.27 $ 12.38 $ 12.32 $ 13.70 $ 13.18
------- ------- ------- ------- ------- ------ ------ ------ ------ ------
Net investment income.... $ .33 $ .09 $ .04 $ .05 $ .09 $ .16 $ .19 $ .22 $ .22 $ .31
Net realized and
unrealized gain on
investment securities... 7.63 3.62 2.30 2.26 4.63 1.64 2.09 1.20 .03 2.05
------- ------- ------- ------- ------- ------ ------ ------ ------ ------
Total from investment
operations.............. $ 7.96 $ 3.71 $ 2.34 $ 2.31 $ 4.72 $ 1.80 $ 2.28 $ 1.42 $ .25 $ 2.36
------- ------- ------- ------- ------- ------ ------ ------ ------ ------
Less distributions:
Dividends from net
investment income....... $ (.26) $ (.08) $ (.03) $ (.05) $ (.10) $ (.18) $ (.23) $ (.21) $ (.47) $ (.37)
Distributions from net
realized capital
gains................... (2.55) (.53) (2.07) (1.52) (.90) (.29) (1.16) (1.15) (1.16) (1.47)
------- ------- ------- ------- ------- ------ ------ ------ ------ ------
Total distributions...... $ (2.81) $ (.61) $ (2.10) $ (1.57) $ (1.00) $ (.47) $ (1.39) $ (1.36) $ (1.63) $ (1.84)
------- ------- ------- ------- ------- ------ ------ ------ ------ ------
Net asset value at end of
year.................... $ 27.55 $ 22.40 $ 19.30 $ 19.06 $ 18.32 $ 14.60 $ 13.27 $ 12.38 $ 12.32 $ 13.70
======= ======= ======= ======= ======= ====== ====== ====== ====== ======
Total investment
return*................. 36.84% 19.77% 13.13% 14.23% 33.82% 14.41% 18.73% 12.27% 2.80% 20.49%
Ratios/supplemental data:
Net assets at end of year
(in $000's)............. 399,282 236,656 165,684 134,169 109,581 88,428 76,825 67,102 58,077 58,289
Ratio of expenses to
average
net assets.............. .87% .95% 1.03% 1.06% 1.08% 1.21% 1.17% .92% .89% .89%
Ratio of net investment
income
to average net assets... 1.28% .48% .20% .29% .55% 1.32% 1.37% 1.77% 1.66% 2.55%
Portfolio turnover
rate.................... 21% 11% 16% 19% 13% 12% 21% 22% 31% 44%
</TABLE>
- ---------------
* Return is based on net asset value per share, adjusted for reinvestment of
distributions, and does not reflect deduction of the sales charge.
INVESTMENT OBJECTIVE AND POLICIES
The investment objective of the Fund is long-term growth of capital. While
current income is a factor in selecting investments, it is a secondary
consideration. The Adviser believes that the Fund's goals can best be achieved
by investing principally in common stocks the Adviser deems to possess
above-average ability to increase in market value. The Fund may also invest in
United States Government and government agency obligations, corporate debt
securities, preferred stocks and convertible securities. Up to 15% of the Fund's
net assets may be invested in lower-rated or comparable unrated debt securities
as described under "Investment Practices, Risks and
Restrictions: -- Fixed-Income Securities" and -- "Lower-Rated Securities and
Related Risks." There is no assurance that the Fund will succeed in achieving
its investment objectives as there is market risk
4
<PAGE> 5
inherent in pursuing the Fund's investment objective and in owning securities of
the type purchased by the Fund.
The Adviser selects common stocks it believes undervalued when considering
various valuation criteria. The Adviser deems the following important in its
stock selection process: current as well as future levels of profitability, book
value, replacement cost of assets and free cash flow. The Adviser attempts to
lessen price risk by not overpaying for earnings of even the best companies.
Furthermore, investments tend to be concentrated in areas which are viewed as
temporarily out-of-favor as evidenced by such factors as low price-to-normalized
earnings ratios and price-to-book value ratios.
The Adviser's emphasis on fundamental analysis of a company's prospects and the
inherent value of its securities generally results in the Fund's portfolio being
invested primarily in medium or smaller sized companies perceived by the average
investor to be unpopular or unfamiliar. Substantially all common stocks the Fund
purchases, however, are either listed on a national securities exchange or
included in the National Association of Securities Dealers Automated Quotation
("NASDAQ") National Market System. The Adviser's value-oriented investment
approach may result in a portfolio which may not reflect all facets of the
national economy and which may differ significantly from the broad market
indices. Smaller companies typically are subject to a greater degree of change
in earnings and business prospects than larger, more established companies. In
addition, securities of smaller companies are traded in lower volume than those
issued by larger companies and may be more volatile than those of larger
companies. In light of these characteristics of smaller companies and their
securities, the Fund may be subject to greater risk than that assumed when
investing in the equity securities of larger companies.
Although the Fund may not invest more than 5% of its total assets in the
securities of any one issuer (except the U.S. Government) at the time of
purchase, changes in market prices and the assets of the Fund may from time to
time cause more than 5% or even 10% of the Fund's assets to be invested in
securities of a single company. Such relative concentration is likely to
increase the volatility of the Fund's net asset value per share.
The Fund may invest up to 10% of its net assets in securities of foreign
issuers. Such investments involve additional risks and opportunities compared
with securities of United States issuers. The Fund can write covered call
options which are listed on a national securities exchange. See "Investment
Practices, Risks and Restrictions" herein and "Investment Policies" in the
Statement of Additional Information.
Security purchases are based primarily on consideration of fundamental value and
earnings expectations rather than short-term stock market expectations. However,
if earnings prospects change, or the value of a security becomes large in
relation to the Fund's total size or it no longer appears to represent an
unusual value, the Fund can sell all or part of the investment regardless of the
length of time held. See "Investment Practices, Risks and
Restrictions -- Portfolio Turnover."
THE FUND AND ITS MANAGEMENT
The Fund is a diversified, open-end management investment company, generally
called a mutual fund, which was incorporated in Delaware on June 24, 1966, and
reincorporated in Maryland on August 1, 1994. A mutual fund provides the
investor a practical and convenient way to invest in a diversified portfolio of
securities by combining resources with others who have similar investment goals.
5
<PAGE> 6
The Fund has discontinued indefinitely the sale of its shares to new investors,
except directors, officers and employees of the Fund, the Adviser and affiliated
companies. The Fund continues to accept additional investments from existing
shareholders, and continues to reinvest dividends and capital gains
distributions with respect to the accounts of existing shareholders who elect
such options. The decision to discontinue sales to new investors reflects
management's belief that unrestrained growth in the Fund's net assets might
impair investment flexibility. The Fund may recommence at any time the offering
of shares to new investors if in the Board of Directors' opinion doing so would
be in the best interests of the Fund and its shareholders.
A board of four directors is responsible for overseeing the Fund's affairs. The
Adviser selects investments for the Fund, provides administrative services and
manages the Fund's business. Robert L. Rodriguez, President of the Fund, and
Principal, Chief Investment Officer and director of the Adviser, is primarily
responsible for the day-to-day management of the Fund's portfolio. Mr. Rodriguez
has been the Chief Investment Officer of the Fund for over twelve years. The
Adviser, together with its predecessors, has been in the investment advisory
business since 1954, serving as investment adviser to the Fund since July 11,
1984. Presently, the Adviser manages assets of approximately $3.5 billion for
five investment companies, including one closed-end investment company, and more
than 40 institutional accounts. All officers of the Fund are also officers of
the Adviser. Certain officers of the Fund are also officers of the Distributor.
The Adviser and the Distributor are indirect wholly owned subsidiaries of United
Asset Management Corporation ("UAM"), a New York Stock Exchange listed holding
company principally engaged, through affiliated firms, in providing
institutional investment management and acquiring institutional investment
management firms.
ADVISORY AGREEMENT. Under the Investment Advisory Agreement dated August 1,
1994, the Fund pays the Adviser a monthly fee computed on the average daily net
assets of the Fund at the annual rate of 0.75% on the first $50 million of net
assets and 0.65% on net assets over $50 million. In addition, the Adviser
receives an amount equal to 0.10% of the Fund's average daily net assets for
each fiscal year in reimbursement for the provision of financial services to the
Fund. The advisory fee is higher than the fee paid by some other mutual funds.
For the last fiscal year, advisory fees plus the cost of financial services paid
by the Fund equaled 0.75% of the Fund's average net assets.
The Adviser pays for office space, facilities, business equipment and salaries,
including the salaries of the Fund's officers. The Fund pays all other expenses,
including the expense of the continuous public offering of Fund shares (such as
registering Fund shares for sale), preparation of prospectuses and reports to
shareholders and printing those prospectuses and reports furnished to existing
shareholders, the cost of transfer agency services, postage, custodial fees,
taxes, and legal and audit expenses. For the last fiscal year, the Fund's total
operating expenses were 0.87% of average net assets. The Fund also pays
brokerage commissions on portfolio transactions.
FPA FUND FAMILY. The Fund is one of four mutual funds in the FPA Fund Family
(collectively, the "FPA Funds"). FPA New Income, Inc. ("New Income"), a
fixed-income fund, seeks current income and long-term total return. FPA
Paramount Fund, Inc. ("Paramount"), which currently is not open to new
investors, seeks a high total investment return, including capital appreciation
and income. FPA Perennial Fund, Inc. ("Perennial"), which is primarily designed
for retirement plans, seeks long-term growth of capital with current income as a
secondary consideration.
The FPA Funds offer exchange privileges and telephone redemptions plus combined
shareholdings for cumulative purchase discounts and letters of intent. These
privileges are more fully described
6
<PAGE> 7
under "Purchase of Shares," "Shareholder Services" and "Redemption of Shares."
The account information form should be used to change information and authorize
these services. Authorizing exchange privileges or telephone redemptions
requires a signature guarantee, which is described under "Redemption of Shares."
The account information form is available from authorized securities dealers
("dealers") or the Distributor.
PRIOR PERFORMANCE INFORMATION. From time to time, the Fund's total average
annual return for 1, 5 and 10 year periods may be quoted in advertisements.
Other total return quotations, aggregate or average, over other time periods may
also be included. Average annual total return reflects the average annual
percentage change in value of an investment in the Fund over the measuring
period. Aggregate total return reflects the total percentage change in value
over the measuring period. Total return calculations assume that dividends and
capital gain distributions paid by the Fund during the period are reinvested in
Fund shares at net asset value. Quotations of total returns reflect the maximum
sales charge, except that the Fund may also provide, in conjunction with such
quotations, additional quotations that do not reflect a sales charge.
Comparative performance information may also be used from time to time in
advertising or marketing of the Fund's shares. The Fund's total return may be
compared to that of other mutual funds with similar investment objectives and to
stock and other relevant indices or to rankings prepared by independent services
or other financial or industry publications that monitor the performance of
mutual funds. For example, the total return on Fund shares may be compared to
data prepared by Lipper Analytical Services, Inc. or to a stock index such as
the Standard & Poor's 500 Stock Index. Such comparative performance information
may be stated in the same terms in which the comparative data and indices are
stated. For these purposes, the performance of the Fund, as well as the
performance of other mutual funds or indices, would not reflect sales charges,
the inclusion of which would reduce such performance quotations.
Performance figures represent historic earnings, and should not be considered as
representative of future results. The investment return and principal value of
an investment in the Fund will fluctuate so that an investor's shares, when
redeemed, may be worth more or less than their original cost. Since performance
will fluctuate, performance data for the Fund should not be used to compare an
investment in the Fund's shares with bank deposits, savings accounts and similar
investment alternatives which often provide an agreed or guaranteed fixed yield
for a stated period of time. Investors should remember that performance is
generally a function of the kind and quality of the securities held in a
portfolio, operating expenses and market conditions.
Further information about the Fund's performance is contained in the annual
report to shareholders which may be obtained without charge from the Distributor
at the address shown on the cover page of this Prospectus.
PURCHASE OF SHARES
Fund shares are sold through dealers in a continuous offering to the classes of
investors described on the cover page of this Prospectus. The Distributor serves
as principal underwriter for Fund shares, which are available for purchase at
the offering price through dealers. The minimum initial investment is $1,500.
Each subsequent investment must be at least $100. Minimum investment
requirements can be changed by the Fund or waived by the Distributor. All
purchases made by check should be in U.S. dollars and made payable to the FPA
Funds or State Street Bank and Trust
7
<PAGE> 8
Company. Third party checks will not be accepted. A charge may be imposed if any
check used for investment does not clear.
Offering price equals net asset value per share plus the applicable sales
charge. Orders received by dealers before the New York Stock Exchange ("NYSE")
closes (currently 4:00 p.m., New York time) on any business day are priced based
on net asset value for that day if Boston Financial Data Services, Inc.
("Shareholder Service Agent"), as agent for the Distributor, receives the order
prior to its close of business. Orders received by the Shareholder Service Agent
after such time are priced based on net asset value for the next business day.
NET ASSET VALUE. Net asset value is computed as of the close of the NYSE on
each day the NYSE is open. Net asset value, rounded to the nearest cent per
share, equals the market value of all portfolio securities plus other assets,
less all liabilities, divided by the number of Fund shares outstanding.
TABLE OF SALES CHARGES. The following table shows the sales charge at various
investment levels. The sales charge applies to purchases made at one time by any
combination of an individual, his or her spouse and these related investors (and
their spouses): grandparents, parents, siblings, children or grandchildren; or
by the individual, his or her spouse and a trustee or other fiduciary purchasing
securities for related trusts, estates or fiduciary accounts, including employee
benefit plans.
<TABLE>
<CAPTION>
SALES SALES REALLOWED
SIZE OF INVESTMENT CHARGE(1) CHARGE(2) TO DEALERS(2)
- ------------------------------------------------------- --------- --------- -------------
<S> <C> <C> <C>
Less than $10,000...................................... 6.95% 6.50% 6.00%
$ 10,000 but less than $25,000....................... 6.38% 6.00% 5.50%
$ 25,000 but less than $50,000....................... 5.54% 5.25% 4.75%
$ 50,000 but less than $100,000...................... 4.71% 4.50% 4.25%
$ 100,000 but less than $250,000...................... 3.90% 3.75% 3.50%
$ 250,000 but less than $500,000...................... 2.04% 2.00% 1.75%
$ 500,000 but less than $1,000,000.................... 1.01% 1.00% 0.80%
$1,000,000 and over.................................... 0.00% 0.00% 0.00%
</TABLE>
- ---------------
(1) As a percentage of net amount invested.
(2) As a percentage of public offering price.
CUMULATIVE PURCHASE DISCOUNT. The size of investment may be determined by
adding the amount being invested to the current value, at offering price, of all
presently held shares of the FPA Funds. If such holdings qualify for a reduced
sales charge, information sufficient to permit verification must be furnished to
the Shareholder Service Agent on the account information form or when the order
is placed.
LETTER OF INTENT. A letter of intent ("LOI") allows investors to obtain a
reduced sales charge by aggregating investments made during a 13-month period.
The value of all presently held shares of the FPA Funds may also be used to
determine the applicable sales charge. The minimum initial purchase for an LOI
is $1,500. The account information form contains the LOI which must be signed at
the time of initial purchase, or within 30 days. Each investment made under an
LOI during the period receives the sales charge for the total investment goal.
If the goal is not achieved within the period, the shareholder must pay the
amount equal to the sales charge applicable to the purchases made minus those
actually paid.
8
<PAGE> 9
SALES AT NET ASSET VALUE. Fund shares may be purchased at net asset value,
without a sales charge, by these investors and their spouses (and their
immediate relatives): (a) current and former directors, officers and employees
of the Adviser, UAM and its affiliates; (b) current and former directors,
officers and employees of Angeles Corporation (the former parent of the Adviser)
and its affiliates; (c) current and former directors of, and partners and
employees of legal counsel to, the investment companies advised by the Adviser;
(d) investment advisory clients of the Adviser and pension consultants to such
clients and their directors, officers and employees; (e) employees (including
registered representatives) of a dealer which has a selling group agreement with
the Distributor and consents to such purchases; (f) any employee benefit plan
maintained for the benefit of such qualified investors; and (g) directors,
officers and employees of a company whose employee benefit plan holds shares of
one or more of the FPA Funds. Immediate relatives include grandparents, parents,
siblings, children and grandchildren of a qualified investor, and the spouse of
any immediate relative. The foregoing purchasers must represent that the shares
are purchased for investment and will not be resold except through redemption or
repurchase by the Fund.
The Fund also offers shares at net asset value without imposition of a sales
charge to the following persons: (i) trustees or other fiduciaries purchasing
shares for employee benefit plans of employers with 20 or more employees; (ii)
trust companies, bank trust departments and registered investment advisers
purchasing for accounts over which they exercise investment authority and which
are held in a fiduciary, agency, advisory, custodial or similar capacity,
provided that the amount collectively invested or to be invested by such
accounts during the subsequent 13-month period in the Fund and/or the FPA Funds
totals at least $1,000,000; (iii) tax-exempt organizations enumerated in Section
501(c) (3), (9), or (13) of the Internal Revenue Code; and (iv) accounts upon
which an investment adviser, financial planner or broker-dealer charges an
account management or consulting fee, provided such organization has entered
into an agreement with the Distributor regarding such accounts or purchases Fund
shares for such accounts or for its own accounts through an omnibus account
maintained by a broker-dealer that has entered into such an agreement with the
Fund or Distributor.
No sales charge is imposed because the Distributor anticipates that such
purchases should result in economies in the sales effort and related expenses
compared to sales made through normal distribution channels. A special
application form, which is available from the Distributor, must be submitted
with the initial purchase. All net asset value sales require specific
notification to the Distributor of the purchaser's eligibility at the time the
order is placed. If a purchaser places such an order through a securities
broker, the broker may charge a service fee. No such fee is charged if shares
are purchased directly from the Distributor or the Fund.
SHAREHOLDER SERVICES
FPA EXCHANGE PRIVILEGE. Subject to the following requirements, Fund shares may
be exchanged for shares of another FPA Fund, except FPA Paramount Fund, Inc.,
whose shares may only be acquired by existing Paramount shareholders. An
exchange may establish a new or increase an existing FPA Fund account. Both
accounts must bear the same registration. A sales charge applies to the purchase
by exchange unless (a) a sales charge equivalent to that applicable to the
acquired shares was previously paid; (b) the shareholder is entitled to purchase
shares at net asset value; or (c) the shares being exchanged were acquired by
reinvestment. Shares of the fund to be acquired must be registered for sale in
the investor's state. A $5.00 service fee applies to each exchange.
9
<PAGE> 10
MONEY MARKET FUND EXCHANGE PRIVILEGE. The Distributor has arranged for shares
of the money market portfolio of the Cash Equivalent Fund, a no-load diversified
open-end money market mutual fund ("Money Market Fund") to be available in
exchange for shares of the Fund. Shares of the Money Market Fund so acquired
plus any shares acquired through reinvestment of dividends and distributions may
be re-exchanged for shares of any FPA Fund without sales charge, provided that
in the case of the Fund and of Paramount, the investor has maintained his
shareholder account because shares of the Fund and of Paramount are currently
offered only to existing shareholders. The $5.00 exchange fee is paid by the
Distributor which receives a fee from Kemper Financial Services, the
administrator for the Money Market Fund, of .15 of 1% per year or more of the
average daily net asset value of shares of the Money Market Fund acquired
through this exchange privilege. This exchange privilege does not constitute an
offering or recommendation by the Fund of the Money Market Fund. The Money
Market Fund is separately managed and is not one of the FPA Funds. FPA mutual
fund investments held in Fund-Sponsored Individual Retirement Accounts may not
be exchanged into the Cash Equivalent Fund.
HOW TO EXCHANGE SHARES. The above described exchange privileges may be
exercised by sending written instructions to the Shareholder Service Agent. See
"Redemption of Shares" for applicable signature and signature guarantee
requirements. Exchange privileges may also be exercised by telephone as
described under "Redemption of Shares -- Telephone Transactions." Only four
exchanges may be made in one account during any calendar year; exchanges
exceeding this limit may be considered null and void, if the investor has been
notified that this limit has been reached. Shares must be owned for 15 days
before exchanging and cannot be in certificate form unless the certificate is
tendered with the request for exchange. An exchange requires the purchase of
shares of the acquired fund with a value of at least $1,000. Exchange
redemptions and purchases are effected on the basis of the net asset values next
determined after receipt of the request in proper order by the Shareholder
Service Agent. In the case of exchanges into the Money Market Fund, dividends
generally commence on the following business day. For federal and state income
tax purposes, an exchange is treated as a sale and may result in a capital gain
or loss, although if the shares exchanged have been held less than 91 days, the
sales charge paid on such shares is not included in the tax basis of the
exchanged shares, but is carried over and included in the tax basis of the
shares acquired. See the Statement of Additional Information.
Additional information concerning this privilege and prospectuses for other FPA
Funds and/or for the Money Market Fund may be obtained from dealers or the
Distributor. A shareholder should read such prospectuses and consider
differences in objectives and policies before making any exchange. The Fund or
the Distributor can change or discontinue this privilege upon 60 days' advance
notice and investors who had exchanged into the Money Market Fund would be
permitted to reacquire shares of the Fund without sales charge for at least 60
days after notice of termination of the Money Market Fund exchange privilege.
INVESTMENT ACCOUNT. Each shareholder has an investment account in which the
Shareholder Service Agent holds Fund shares. Unless the Shareholder Service
Agent receives a written request, stock certificates will not be issued.
Certificates are only issued for full shares. The shareholder receives a
statement showing account activity after each transaction.
PRE-AUTHORIZED INVESTMENT PLAN. An investor desiring to make automatic monthly
investments may use the optional shareholder services form, available from
dealers or the Distributor. The
10
<PAGE> 11
Shareholder Service Agent withdraws funds from the investor's bank account
monthly for $100 or more as specified through the Automated Clearing House.
RETIREMENT PLANS. An eligible investor may establish an IRA (individual
retirement account) and/or other retirement plan with a $100 minimum initial
investment and an expressed intention to increase the investment to $1,500
within 12 months. Each subsequent investment must be at least $100. Neither the
Fund nor the Distributor imposes additional fees for these plans, but the plan
custodian does. The Tax Reform Act of 1986 restricted deductible contributions
to an IRA by participants in an employer-sponsored retirement plan. The maximum
deductible contribution of $2,000 of earned income is phased out for such
participants with an adjusted gross income of $40,000 to $50,000 (joint) or
$25,000 to $35,000 (single). However, persons ineligible for deductible
contributions generally may make non-deductible contributions of earned income
up to $2,000 per year and earnings are tax-deferred. Investors should consult
their tax advisers. Forms and information regarding the plan are available from
dealers or the Distributor.
SYSTEMATIC WITHDRAWAL PLAN. Any shareholder whose account value is $10,000 or
more may make monthly, quarterly, semi-annual or annual withdrawals of $50 or
more by completing the optional shareholder services form. Under this plan,
sufficient Fund shares to cover these withdrawals are redeemed each month and
proceeds are forwarded as directed on the optional shareholder services form.
Dividends and capital gains distributions on Fund shares held under this plan
are automatically reinvested in additional Fund shares at net asset value. If
these withdrawals continuously exceed reinvestments, the shareholder's account
is correspondingly reduced and ultimately exhausted. Concurrent withdrawals and
purchases are ordinarily disadvantageous to the shareholder due to additional
sales charges. The shareholder recognizes any taxable gain or loss on
redemptions.
REDEMPTION OF SHARES
Shareholders can redeem for cash, without charge, any or all of their Fund
shares at any time by sending a written request in proper form to the
Shareholder Service Agent. Facsimile transmissions are not acceptable.
Shareholders can also place redemption requests through dealers, who may charge
a fee. Shareholders redeeming Fund shares from retirement plans should consult
the plan documents concerning federal tax consequences and their plan custodian
regarding procedures.
All persons in whose name the account is established must sign the redemption
request exactly as registered. If the redemption exceeds $10,000, if the
proceeds are not paid to the record owner at the record address, or if the
shareholder is a corporation, partnership, trust or fiduciary, the signature(s)
must be guaranteed by a bank or trust company; a broker or dealer; a credit
union; a national securities exchange, registered securities association or
clearing agency; or a savings and loan association.
In most cases, only a properly signed request with any necessary signature
guarantee is required for a redemption. However, stock certificates, if held by
shareholders, must accompany requests. Additional documents are required if a
corporation, partnership, trust, fiduciary, executor or administrator requests
the redemption.
Redemptions are only processed on days the NYSE is open. The redemption price is
the first net asset value determined after the Shareholder Service Agent
receives the redemption request in proper form. A check for the proceeds is
mailed within seven days after the Shareholder Service
11
<PAGE> 12
Agent receives the request in good order. If Fund shares were recently purchased
by check, redemptions will not be allowed until the investment being redeemed
has been in the account for 15 days.
The Fund may direct the Shareholder Service Agent to redeem all Fund shares of
any shareholder whose account value is less than $500 as a result of a
redemption. In such case, the shareholder is notified in writing that the
account value is insufficient and allowed up to 60 days to increase it to $500.
TELEPHONE TRANSACTIONS. Telephone exchange privileges are available unless
declined by an investor on the account information form. Telephone redemption
privileges are available only if elected on the optional shareholder services
form. A properly completed request with a signature guarantee is required if a
telephone redemption election is made or changed after the account is opened.
Telephone redemptions are not available for shares held in a Fund-sponsored
retirement account. Shares held in certificate form cannot be redeemed or
exchanged by telephone. The Shareholder Service Agent (the "Agent") employs
procedures considered by it to be reasonable to confirm that instructions
communicated by telephone are genuine, including requiring account registration
verification from the caller and recording telephone instructions. If reasonable
procedures are employed, neither the Agent nor the Fund is responsible for
following telephone instructions the Agent reasonably believes to be genuine.
The Agent and the Fund may be liable for any losses due to unauthorized or
fraudulent instructions if such loss results from a failure to employ reasonable
procedures. Proceeds of telephone redemptions are paid to the bank account the
shareholder designates when establishing this privilege. Telephone redemptions
of $5,000 or more are wired unless the designated bank cannot receive Federal
Reserve wires. Telephone redemptions under $5,000 are mailed unless a wire is
requested. There is a $3.50 charge for wires. During periods of significant
economic or market changes, telephone instructions may be difficult to place. If
an investor is unable to contact the Agent by telephone, instructions may be
sent to the Agent at the address set forth on page 2. The Fund may change or
discontinue telephone redemption privileges without notice.
REINVESTMENT PRIVILEGE. Proceeds from a redemption can be reinvested in Fund
shares within 30 days without paying a sales charge. Such reinvestment is made
at the first net asset value determined after the Shareholder Service Agent
receives the order. This privilege can be exercised only once for each Fund
investment. Information sufficient to permit verification must be furnished to
the Shareholder Service Agent when the purchase is placed. Such redemption and
reinvestment is a taxable transaction but losses on the redemption are not
deductible for federal income tax purposes.
DIVIDENDS, DISTRIBUTIONS AND TAXES
Shareholders may receive dividends and/or capital gains distributions in
addition to any increase or decrease in the value of Fund shares. Dividends and
distributions are automatically reinvested in additional Fund shares at the net
asset value determined at the close of business on the day after the record
date, unless the Shareholder Service Agent receives a written request for cash
payment before the record date. The account information form may be used for
this purpose.
12
<PAGE> 13
DIVIDENDS. The Fund's investment income consists principally of dividends and
interest earned on its portfolio securities. All of this income, after payment
of expenses, is distributed semi-annually as dividends to shareholders.
CAPITAL GAINS. When the Fund sells portfolio securities, it realizes capital
gains and losses, depending upon whether the selling price is higher or lower
than the purchase price. Net realized capital gains from sales of securities
equal profits minus losses, including any losses carried forward from prior
years. The Fund distributes any net realized capital gains to shareholders at
least annually.
TAXES. Because the Fund plans to distribute all of its net investment income
and net realized capital gains to shareholders, it does not expect to pay any
federal income tax. Dividends and distributions paid to shareholders are subject
to federal income tax, and any state and local income tax. Shareholders are
notified annually of the federal tax status of these distributions. Dividends
from net investment income and distributions from short-term capital gains are
taxable to shareholders as ordinary income. Distributions from long-term capital
gains are taxable to shareholders as such. All distributions are taxable whether
paid in cash or reinvested. To avoid a 31% federal withholding tax on dividends,
distributions and redemptions, shareholders must certify their taxpayer
identification number to the Shareholder Service Agent, as agent for the Fund.
The account information form may be used for this purpose.
INVESTMENT PRACTICES, RISKS AND RESTRICTIONS
FIXED-INCOME SECURITIES. The market price of fixed-income securities held by
the Fund can be expected to vary inversely to changes in prevailing interest
rates. Investments in fixed-income securities with longer maturities generally
produce higher yields but are subject to greater market fluctuation.
MORTGAGE-BACKED SECURITIES. The Fund may invest in mortgage-backed securities
which represent an interest in a pool of mortgage loans. The primary government
issuers or guarantors of mortgage-backed securities are GNMA, FNMA and FHLMC.
Mortgage-backed securities are also issued by certain private, nongovernmental
corporations, such as financial institutions. Mortgage-backed securities provide
a monthly payment consisting of interest and principal payments. Additional
payments may be made out of unscheduled repayments of principal resulting from
the sale of the underlying residential property, refinancing or foreclosure, net
of fees or costs that may be incurred. Prepayments of principal on
mortgage-related securities may tend to increase due to refinancing of mortgages
as interest rates decline. Prompt payment of principal and interest on GNMA
mortgage pass-through certificates is backed by the full faith and credit of the
United States. FNMA guaranteed mortgage pass-through certificates and FHLMC
participation certificates are solely the obligations of those entities but are
supported by the discretionary authority of the U.S. Government to purchase the
agencies' obligations. To the extent that the Fund purchases mortgage-backed
securities at a premium, prepayments may result in some loss of the Fund's
principal investment to the extent of the premium paid. In addition, like other
debt securities, the value of mortgage-related securities will generally
fluctuate in response to market interest rates.
Collateralized mortgage obligations ("CMOs") are a type of bond secured by an
underlying pool of mortgages or mortgage pass-through certificates that are
structured to direct payments on underlying collateral to different series or
classes of the obligations. CMOs issue a series of bonds or certificates in
multiple classes. Each class, often referred to as a "tranche," is issued at a
specific
13
<PAGE> 14
fixed or floating coupon rate and has a stated maturity or final distribution
date. Interest is paid or accrues on all classes of the CMOs on a monthly,
quarterly or semi-annual basis. Principal prepayments on the underlying pool of
mortgages may cause the CMOs to be retired substantially earlier than their
stated maturities or final distribution dates. Changes in estimated prepayment
rates alter the expected life of mortgage-backed securities. In periods of sharp
interest rate movements and/or in periods of supply and demand imbalances in the
market for such securities, the prices of certain CMOs may fluctuate to a
greater extent than would be expected from interest rate movements alone. For
example, an increase in interest rates would not only likely decrease the value
of CMOs owned by the Fund but would also increase the inherent volatility of the
Fund by effectively lengthening the expected life of these securities.
A variety of CMO certificates may be issued in sequential pay structures. These
securities include accrual certificates (also known as "Z-bonds") which only
accrue interest at a specified rate until all other certificates having an
earlier final distribution date have been retired and are converted thereafter
to an interest-paying security. The market prices of CMOs structured as accrual
bonds are affected to a greater extent by interest rate changes and therefore
tend to be more volatile than securities which pay interest periodically and in
cash.
The Fund may invest up to 5% of its net assets in interest-only classes of
stripped mortgage-backed securities. The prices of these securities are likely
to be volatile in the event of changes in mortgage prepayment rates, or
expectations related thereto, as described in the Statement of Additional
Information. In addition, these securities tend to be less liquid than other
CMOs.
LOWER-RATED SECURITIES AND RELATED RISKS. The Fund may invest up to 15% of its
net assets in fixed-income securities, including convertible securities, which
are rated BB or lower, by Standard & Poor's Corporation ("S&P") or Ba or lower
by Moody's Investors Service, Inc. ("Moody's"), which ratings are considered by
the rating agencies to be speculative, and unrated securities considered by the
Adviser to be of comparable quality. Debt securities with a rating of BB/Ba or
lower are commonly referred to as "junk bonds."
To the extent that convertible securities or other debt securities acquired by
the Fund are rated lower than investment grade or are not rated, there is a
greater risk as to the timely repayment of the principal of, and timely payment
of interest on, such securities. Decisions to purchase and sell these securities
are based on the Adviser's evaluation of their investment potential and not on
the ratings assigned by credit agencies. Because investment in lower-rated
securities involves greater investment risk, achievement of the Fund's
investment objective is more dependent on the Adviser's credit analysis than
with respect to the Fund's investments in higher-rated securities. Lower-rated
securities may be more susceptible to real or perceived adverse economic and
competitive industry conditions than investment grade securities. A projection
of an economic downturn, for example, could cause a decline in the prices of
lower-rated securities because the advent of a recession could lessen the
ability of a highly leveraged company to make principal and interest payments on
its debt securities. In addition, the secondary trading market for lower-rated
securities may be less liquid than the market for higher-rated securities.
Prices of lower-rated securities may decline rapidly in the event a significant
number of holders decides to sell. Changes in expectations regarding an
individual issuer, an industry or lower-rated securities generally could reduce
market liquidity for such securities and make their sale by the Fund more
difficult, at least in the absence of price concessions. The lower-rated bond
market has grown
14
<PAGE> 15
primarily during a period of long economic expansion and it is uncertain how it
would perform during an extended economic downturn. An economic downturn or an
increase in interest rates could severely disrupt the market for lower-rated
bonds and adversely affect the value of outstanding bonds and the ability of the
issuers to repay principal and interest. See "Risk Factors Relating to
Lower-Rated Securities" in the Statement of Additional Information for a further
discussion.
The lower-rated securities in which the Fund may invest from time to time
include debt securities of companies that are financially troubled, in default
or are in bankruptcy or reorganization ("Deep Discount Securities"). These
securities may be rated C, C1 or D by S&P or C by Moody's or may be unrated.
Debt obligations of such companies are usually available at a deep discount from
the face value of the instrument. The Fund may invest in Deep Discount
Securities when the Adviser believes that existing factors are likely to improve
the company's financial condition. Such factors include a restructuring of debt,
management changes, existence of adequate assets, or other special
circumstances.
A debt instrument purchased at a deep discount, but prior to default, may
currently pay a very high effective yield. In addition, if the financial
condition of the issuer improves the underlying value of the securities may
increase, resulting in a capital gain. If the issuer defaults on its obligations
or remains in default, or if the plan of reorganization is insufficient for
debt-holders, the Deep Discount Securities may stop generating income and lose
value or become worthless. The Adviser will balance the benefits of Deep
Discount Securities with their risks. While a diversified portfolio may reduce
the overall impact of a Deep Discount Security that is in default or loses its
value, the risk cannot be eliminated.
As of March 31, 1996, none of the Fund's net assets were invested in convertible
securities, 6.5% of the Fund's net assets were invested in U.S. Government and
agency securities, and 14.2% of the Fund's net assets were held in high grade
short-term investments.
SECURITIES OF FOREIGN ISSUERS. Investments in securities of foreign issuers may
be affected favorably or unfavorably by changes in currency rates and exchange
control regulations. Compared to U.S. companies, there may be less publicly
available information about foreign companies which generally are subject to
less stringent accounting, auditing and financial reporting standards and
requirements. Securities of some foreign companies may be less liquid or more
volatile than those of U.S. companies. Foreign brokerage commissions and
custodial fees are generally higher than in the United States. Investments in
foreign securities may involve additional risks, including local political or
economic developments, expropriation or nationalization of assets and imposition
of withholding taxes on dividend or interest payments. In the event of a default
on any foreign debt obligation, it may be more difficult for the Fund to obtain
or enforce a judgment against the issuer.
COVERED CALL OPTIONS. When the Fund writes a listed call option, the purchaser
has the right to buy a security from the Fund at a fixed exercise price any time
before the option contract expires, regardless of changes in the market price of
the underlying security. The Fund writes options only on securities it owns
(covered options) and must retain ownership of the underlying security while the
option is outstanding. Until the option expires, the Fund cannot profit from a
rise in the market price of the underlying security over the exercise price,
except insofar as the premium which the Fund receives, net of commissions,
represents a profit. The premium paid to the Fund is the consideration for
undertaking this obligation.
15
<PAGE> 16
The Fund may not write any option which, at the time, would cause its
outstanding options to cover securities comprising more than 10% of its asset
value. Writing option contracts is a highly specialized activity and may limit
investment flexibility at certain times. The maximum term for listed options
exceeds two years, but the Fund expects that most options it writes will not
exceed six months.
SHORT SALES AGAINST THE BOX. The Fund can make short sales of securities or
maintain a short position if the Fund contemporaneously owns or has the right to
obtain at no added cost securities identical to those sold short (short sales
"against the box") or if the securities sold are "when issued" or "when
distributed" securities which the Fund expects to receive in a recapitalization,
reorganization, or other exchange for securities the Fund contemporaneously owns
or has the right to obtain at no added cost. The principal purpose of making
short sales is to enable the Fund to obtain the current market price of a
security which the Fund desires to sell but which cannot be currently delivered
for settlement. The Fund may not make short sales or maintain a short position
if to do so would cause more than 25% of its total net assets (exclusive of
proceeds from short sales) to be allocated to a segregated account in connection
with short sales.
REPURCHASE AGREEMENTS. The Fund may invest up to 20% of its total assets in
repurchase agreements with domestic banks or dealers to earn interest on
temporarily available cash. A repurchase agreement is a short-term investment in
which the purchaser (i.e., the Fund) acquires a debt security and the seller
agrees to repurchase at a future time and set price, thereby determining the
yield during the holding period. Repurchase agreements are collateralized by the
underlying debt securities and may be considered loans under the Investment
Company Act of 1940 ("Investment Company Act"). In the event of bankruptcy or
other default by the seller, the Fund may experience delays and expenses
liquidating the underlying security, loss from decline in value of such
security, and lack of access to income on such security. The Fund will not
invest more than 10% of its total assets in repurchase agreements which mature
in more than seven days and/or other securities which are not readily
marketable.
BROKERAGE PRACTICES. The Adviser is responsible for placing orders for the
purchase and sale of portfolio securities and negotiating brokerage commissions
on such transactions. Brokerage firms are selected for their professional
capability and the overall value and quality of their execution services. The
Adviser is authorized to pay higher commissions to brokerage firms providing
investment and research information if the Adviser deems such commissions
reasonable in relation to the overall services provided. The Adviser may also
use information received to manage the assets of other advisory accounts. The
Fund does not pay any mark-up over the market price of securities acquired in
principal transactions with dealers.
PORTFOLIO TURNOVER. The Fund purchases securities primarily for investment
rather than short-term trading. However, changes are made in the portfolio
whenever it appears advisable. The Fund's annual portfolio turnover rate is
shown in the table of "Financial Highlights." Greater portfolio activity
increases the Fund's transaction costs, including brokerage commissions.
INVESTMENT RESTRICTIONS. The Fund has adopted investment restrictions which,
like its investment objectives, cannot be changed without approval by a majority
(as defined in the Investment Company Act) vote of the Fund's shareholders.
These restrictions provide, in part, that the Fund shall not:
1. Borrow any amount other than as a temporary measure for extraordinary or
emergency purposes as determined by the Fund's Board of Directors;
16
<PAGE> 17
2. Concentrate more than 25% of the value of its assets in a particular
industry;
3. Purchase the securities of any one issuer (except securities issued by
the United States of America, or any instrumentality thereof) if the
holdings of the Fund in the securities of such issuer exceed 5% of the
market value of the Fund's total assets; or
4. Purchase the securities of any one issuer causing the Fund's holdings to
exceed 10% of the outstanding voting securities of such issuer or 10% of
any class of securities of such issuer.
Percentage limitations are calculated and applied at the time of investment.
Additional information concerning the Fund's investment practices and
restrictions is contained in the Statement of Additional Information.
OTHER INVESTMENT RESTRICTIONS. The Fund has adopted certain investment
restrictions that may be changed by the Board of Directors. One of these
restrictions provides that the Fund shall not purchase Rule 144A securities in
an amount exceeding 5% of the Fund's net assets or purchase other securities
subject to legal or contractual restrictions on resale in an amount exceeding 5%
of the Fund's net assets. See the Statement of Additional Information.
ADDITIONAL INFORMATION
COMMON STOCK. Each Fund share outstanding participates equally in dividends,
distributions and liquidation of the Fund's net assets. Fund shares are
transferable, fully paid and non-assessable, and do not have any preemptive,
preferential, subscription or conversion rights. The Fund has authorized 100
million shares of $0.01 par value Common Stock.
VOTING RIGHTS. The By-Laws of the Fund provide that shareholder meetings are
required to be held to elect directors only when required by the Investment
Company Act. Such event is likely to occur infrequently. In addition, a special
meeting of the shareholders will be called, if requested by the holders of ten
percent of the Fund's outstanding shares, for the purposes, and to act upon the
matters, specified in the request (which may include election or removal of
directors). When matters are submitted for a shareholder vote, each shareholder
is entitled to one vote for each share owned.
SHAREHOLDER INQUIRIES. Shareholders who have questions concerning (1) the Fund
may contact the Distributor; (2) their account may contact the Shareholder
Service Agent; and (3) their retirement plan may contact the Shareholder Service
Agent. The applicable addresses and telephone numbers appear on page 2.
SHAREHOLDER SERVICE AGENT. Boston Financial Data Services, Inc., P. O. Box
8500, Boston, Massachusetts 02266-8500, serves as shareholder service and
dividend disbursing agent for the Fund. State Street Bank and Trust Company
serves as transfer agent for the Fund.
CUSTODIAN. All cash and securities of the Fund are held by the Fund's
custodian, State Street Bank and Trust Company, 225 Franklin Street, Boston,
Massachusetts 02110.
LEGAL COUNSEL. O'Melveny & Myers LLP, 400 South Hope Street, Los Angeles,
California 90071, provides legal services to the Fund.
INDEPENDENT AUDITORS. Ernst & Young LLP, 515 South Flower Street, Los Angeles,
California 90071, performs annual audits of the Fund's financial statements.
17
<PAGE> 18
STATEMENT OF ADDITIONAL INFORMATION
August 1, 1996
FPA CAPITAL FUND, INC.
Statement of Additional Information ("Statement") supplements the current
Prospectus of FPA Capital Fund, Inc. ("Fund") dated August 1, 1996. This
Statement does not present a complete picture of the various topics discussed
and should be read in conjunction with the Fund's Prospectus. Although this
Statement is not itself a Prospectus, it is, in its entirety, incorporated by
reference into the Prospectus. The Fund's Prospectus may be obtained by
contacting your securities dealer or the Fund's principal underwriter, FPA Fund
Distributors, Inc. ("Distributor"), at 11400 West Olympic Boulevard, Suite 1200,
Los Angeles, California 90064; telephone (310) 473-0225 or (800) 982-4372,
except from Alaska, Hawaii and Puerto Rico.
TABLE OF CONTENTS
Page
General Information....................................................... 2
Voting Rights.................................................... 2
Report to Shareholders........................................... 2
Investment Policies....................................................... 2
Mortgage-Backed Securities....................................... 2
Guaranteed Mortgage Pass-Through Securities...................... 3
Collateralized Mortgage Obligations and Multiclass
Pass-Through Securities.......................................... 3
Stripped Mortgage-Backed Securities.............................. 4
Securities of Foreign Issuers.................................... 4
Covered Call Options............................................. 5
Short Sales Against the Box...................................... 5
Repurchase Agreements............................................ 6
Rule 144A and Other Restricted Securities........................ 6
Ratings ................................................................. 7
Debt Security Ratings............................................ 7
Moody's.......................................................... 7
S&P.............................................................. 8
Commercial Paper Ratings......................................... 9
Risk Factors Relating to Lower-Rated Securities........................... 9
Investment Restrictions................................................... 11
Additional Restrictions.......................................... 12
Directors and Officers of the Fund........................................ 13
Five Percent Shareholders........................................ 15
Investment Advisory Agreement............................................. 15
Prior Performance Information............................................. 17
Portfolio Transactions and Brokerage...................................... 19
Portfolio Turnover........................................................ 20
Distributor............................................................... 20
Purchase and Redemption of Shares......................................... 21
Net Asset Value.................................................. 21
Sales Charges.................................................... 21
Sales at Net Asset Value......................................... 21
Letter of Intent................................................. 21
FPA Exchange Privilege........................................... 22
Redemption of Shares............................................. 23
Telephone Redemption............................................. 23
Tax Sheltered Retirement Plans............................................ 24
Dividends, Distributions and Taxes........................................ 24
Financial Statements...................................................... 26
1
<PAGE> 19
GENERAL INFORMATION
Voting Rights. Fund shares do not have cumulative voting rights, which means
holders of more than 50% of Fund shares voting for the election of directors can
elect 100% of the directors if they so choose. In such event, holders of the
remaining Fund shares are not able to elect any person or persons to the Fund's
Board of Directors.
Reports to Shareholders. Shareholders receive semi-annual and annual reports
which show the portfolio of investments, major portfolio changes and other
information. Financial statements accompanied by an opinion of independent
auditors are furnished to shareholders after the Fund's fiscal year-end.
Unaudited financial statements prepared by the Fund are provided after the first
six months of the fiscal year.
INVESTMENT POLICIES
The following supplements information set forth under the captions "Investment
Objective and Policies" and "Investment Practices, Risks and Restrictions" in
the Prospectus. Readers must also refer to the Prospectus.
Mortgage-Backed Securities. The mortgage-backed securities in which the Fund may
invest may include those backed by the full faith and credit of the United
States. Government National Mortgage Association ("GNMA"), the principal U.S.
guarantor of such securities, is a wholly owned U.S. Government corporation
within the Department of Housing and Urban Development. The Fund may also invest
in government-related mortgage-backed securities which are not backed by the
full faith and credit of the United States such as those issued by Federal
National Mortgage Association ("FNMA") and Federal Home Loan Mortgage
Corporation ("FHLMC"). FNMA is a government-sponsored corporation owned entirely
by private stockholders, which is subject to general regulation by the Secretary
of Housing and Urban Development. Pass-through securities issued by FNMA are
guaranteed as to timely payment of principal and interest by FNMA. FHLMC is a
corporate instrumentality of the United States, the stock of which is owned by
the Federal Home Loan Banks. Participation certificates representing interests
in mortgages from FHLMC's national portfolio are guaranteed as to the timely
payment of interest and ultimate collection of principal by FHLMC. The Fund may
also invest in mortgage-backed securities issued by certain private
non-governmental corporations, such as financial institutions.
The average maturity of pass-through pools of mortgage-backed securities varies
with the maturities of the underlying mortgage instruments. In addition, a
pool's stated maturity may be shortened by unscheduled payments on the
underlying mortgages. Factors affecting mortgage prepayments include the level
of interest rates, general economic and social conditions, the location of the
mortgaged property and the age of the mortgage. Because prepayment rates of
individual mortgage pools vary widely, it is not possible to accurately predict
the average life of a particular pool. Common industry practice, for example, is
to assume that prepayments will result in a 7- to 9-year average life for pools
of fixed-rate 30-year mortgages. Pools of mortgages with other maturities of
different characteristics will have varying average life assumptions.
2
<PAGE> 20
Guaranteed Mortgage Pass-Through Securities. The Fund may invest in mortgage
pass-through securities representing participation interests in pools of
residential mortgage loans originated by United States governmental or private
lenders and guaranteed, to the extent provided in such securities, by a Federal
Agency. Such securities, which are ownership interests in the underlying
mortgage loans, differ from conventional debt securities, which provide for
periodic payment of interest in fixed amounts (usually semiannually) and
principal payments at maturity or on specified dates. Mortgage pass-through
securities provide for monthly payments (not necessarily in fixed amounts) that
are a "pass-through" of the monthly interest and principal payments (including
any prepayments) made by the individual borrowers on the pooled mortgage loans,
net of any fees paid to the guarantor of such securities and the servicer of the
underlying mortgage loans.
The guaranteed mortgage pass-through securities in which the Fund may invest
include those issued or guaranteed by GNMA, FNMA and FHLMC. GNMA certificates
are direct obligations of the U.S. Government and, as such, are backed by the
"full faith and credit" of the United States. FNMA and FHLMC are federally
chartered, privately owned corporations which are instrumentalities of the
United States. FNMA and FHLMC certificates are not backed by the full faith and
credit of the United States.
Certificates for these types of mortgage-backed securities evidence an interest
in a specific pool of mortgages. These certificates are, in most cases,
"modified pass-through" instruments, wherein the issuing agency guarantees the
payment of principal and interest on mortgages underlying the certificates,
whether or not such amounts are collected by the issuer on the underlying
mortgages.
Collateralized Mortgage Obligations and Multiclass Pass-Through Securities. The
Fund may invest in CMOs which are debt obligations collateralized by mortgage
loans or mortgage pass-through securities. Typically, CMOs are collateralized by
GNMA, FNMA or FHLMC certificates, but also may be collateralized by whole loans
or private mortgage pass-through securities (such collateral is collectively
hereinafter referred to as "Mortgage Assets"). Multiclass pass-through
securities are equity interests in a trust composed of Mortgage Assets. Payments
of principal of and interest on the Mortgage Assets, and any reinvestment income
thereon, provide the funds to pay debt service on the CMOs or make scheduled
distributions on the multiclass pass-through securities. CMOs may be issued by
Federal Agencies, or by private originators of, or investors in, mortgage loans,
including savings and loan associations, mortgage banks, commercial banks,
investment banks and special purpose subsidiaries of the foregoing. The issuer
of a series of CMOs may elect to be treated as a Real Estate Mortgage Investment
Conduit ("REMIC"). REMICs include governmental and/or private entities that
issue a fixed pool of mortgages secured by an interest in real property. REMICs
are similar to CMOs in that they issue multiple classes of securities, but
unlike CMOs, which are required to be structured as debt securities, REMICs may
be structured as indirect ownership interests in the underlying assets of the
REMICs themselves. However, the Fund's investment in a CMO is not effected by
the issuer's election to be treated as a REMIC, and all future references to
CMOs shall also be deemed to include REMICs.
In CMOs, a series of bonds or certificates is issued in multiple classes. Each
class of CMOs, often referred to as a "tranche," is issued at a specific fixed
or floating coupon rate and has a stated maturity or final distribution date.
Principal prepayments on the Mortgage Assets may cause the CMOs to be retired
substantially earlier than their stated maturities or final distribution dates.
3
<PAGE> 21
Interest is paid or accrues on all classes of the CMOs on a monthly, quarterly
or semiannual basis. Certain CMOs may have variable or floating interest rates
and others may be Stripped Mortgage Securities.
The principal of and interest on the Mortgage Assets may be allocated among the
several classes of a CMO series in a number of different ways. Generally, the
purpose of the allocation of the cash flow of a CMO to the various classes is to
obtain a more predictable cash flow to certain of the individual tranches than
exists with the underlying collateral of the CMO. As a general rule, the more
predictable the cash flow is on a CMO tranche, the lower the anticipated yield
will be on that tranche at the time of issuance relative to prevailing market
yields on other mortgage-backed securities. As part of the process of creating
more predictable cash flows on most of the tranches in a series of CMOs, one or
more tranches generally must be created that absorb most of the volatility in
the cash flows on the underlying mortgage loans. The yields on these tranches
are generally higher than prevailing market yields on mortgage-backed securities
with similar maturities. As a result of the uncertainty of the cash flows of
these tranches, the market prices of and yield on these tranches generally are
more volatile.
Stripped Mortgage-Backed Securities. The Fund may invest in stripped
mortgage-backed securities. These securities represent beneficial ownership
interests in either periodic principal distributions (the principal-only or "PO"
class) or interest distributions (the interest-only or "IO" class) on
mortgage-backed certificates. The certificates underlying the stripped
mortgage-backed securities represent all or part of the beneficial interest in
pools of fixed-rate Mortgage Assets. The Fund may invest in IO securities in
order to enhance yield or to benefit from anticipated appreciation in value of
the securities at times when the Adviser believes that interest rates will
remain stable or increase. In periods of rising interest rates, the value of IO
securities may be expected to increase because of the diminished expectation
that the underlying mortgages will be prepaid. In this situation, the expected
increase in the value of IO securities may offset all or a portion of any
decline in value of other debt securities owned by the Fund. Investing in
stripped mortgage-backed securities involves the risks normally associated with
investing in mortgage-backed securities. See "Mortgage-Backed Securities" above
and in the Prospectus. In addition, the yields on IO and PO securities are
extremely sensitive to the prepayment experience on the mortgage loans
underlying the certificates collateralizing the securities. If a decline in the
level of prevailing interest rates results in a rate of principal prepayments
higher than anticipated, distributions of principal will be accelerated, thereby
reducing the yield to maturity on IO securities and increasing the yield to
maturity on PO securities. Conversely, if an increase in the level of prevailing
interest rates results in a rate of principal prepayments lower than
anticipated, distributions of principal will be deferred, thereby increasing the
yield to maturity on IO securities and decreasing the yield to maturity on PO
securities. Sufficiently high prepayments rates could result in the Fund's not
fully recovering its initial investment in an IO security. There can be no
assurance that the Fund will be able to effect a trade of a stripped
mortgage-backed security at a time when it wishes to do so. Stripped
mortgage-backed securities will be considered illiquid securities unless (i)
issued by the United States Government or an agency or instrumentality thereof,
(ii) backed by fixed-rate mortgages, and (iii) there appears to be a liquid
secondary market for the security.
Securities of Foreign Issuers. The Fund may invest up to 10% of its net assets
in securities of foreign governments and companies. Securities of foreign
issuers may be subject to foreign
4
<PAGE> 22
government taxes which could reduce the dividend or interest yield on such
securities. Foreign investments involve certain risks, such as political or
economic instability of the issuer or of the country of issue, the difficulty of
predicting international trade patterns and the possibility of imposition of
exchange controls. Such securities may also be subject to greater fluctuations
in price than those of domestic corporations or the United States Government. In
addition, there may be less publicly available information about a foreign
company than about a domestic company. Foreign companies generally are not
subject to the uniform accounting, auditing and financial reporting standards
applicable to domestic companies. There is generally less government regulation
of stock exchanges, brokers and listed companies abroad than in the United
States. With respect to certain foreign countries, there is a possibility of
expropriation, confiscatory taxation, or diplomatic developments affecting
foreign investments. Finally, in the event of default on any foreign debt
obligation, it may be more difficult for the Fund to obtain or enforce a
judgment against the issuer.
Covered Call Options. In an effort to increase potential income, the Fund is
authorized to write (i.e., sell) covered call options listed on national
securities exchanges. Listed call options are presently traded only with respect
to a limited number of larger companies. Since the Fund does not intend to
purchase securities for the purpose of writing options, it may only be able to
write options on a small portion of its portfolio.
The Fund may terminate its obligation under a previously written option, without
delivery of the underlying security, by effecting a closing transaction, which
is the purchase of a call option on the same security with the same exercise
price and expiration date. The Fund's ability to enter into a closing
transaction may be limited. If the Fund cannot close its position, it is unable
to sell the underlying security until the call expires or is exercised.
Accordingly, the Fund may not be able to sell the underlying security at an
advantageous time. The Fund realizes a profit or loss from a closing transaction
if the cost of the transaction is less or more than the option premium received.
Also, because increases in the market price of an option generally reflect
increases in the market price of the underlying security, any loss realized from
a closing transaction is likely to be offset in whole or in part by the
increased value of the underlying security.
The Fund's portfolio turnover rate may increase to the extent underlying
securities are delivered upon exercise of options written by the Fund. Brokerage
commissions associated with writing call options and effecting closing
transactions are normally proportionately higher than those associated with
general securities transactions.
Short Sales Against the Box. In an effort to increase investment flexibility,
the Fund is authorized to make certain short sales. In a short sale, the Fund
does not immediately deliver the securities sold and does not receive the
proceeds from the sale. The Fund is said to have a short position in the
securities sold until it delivers such securities, at which time it receives the
proceeds of the sale. The Fund must pay the broker the amount of any dividend
paid on the securities while the short position is maintained. To secure its
obligation to deliver the securities sold short, the Fund deposits in escrow in
a segregated account with its custodian an equal amount of the securities sold
short or securities convertible into or exchangeable for such securities.
Common stocks issuable upon conversion of a convertible security sometimes can
be sold at a better price than the convertible security owned by the Fund. In
such circumstances the Fund could sell
5
<PAGE> 23
the common stock short "against the box" while tendering the convertible
security to the issuer for conversion. Upon receipt of the certificates for the
underlying common stock, delivery would be made to close the short sale.
Similarly, when the Fund expects to receive new securities in a reorganization
in exchange for securities owned by the Fund, and the new securities are traded
on a "when issued" basis, the Fund could sell in the "when issued" market and
deliver the new securities when received following the consummation of the
reorganization. If the reorganization is not consummated, all transactions in
the "when issued" market are cancelled in which event the Fund would realize no
gain or loss on the short sale, except for brokerage commissions.
The limited authority to utilize short sales as described above and in the
Prospectus would not subject the Fund to the risk of loss generally associated
with short sales. A short sale "against the box" does eliminate the potential
for gain or loss from subsequent changes in the market price of the security. It
constitutes a form of hedging under which the Fund obtains a current market
price considered attractive by the Adviser, rather than remain subject to future
fluctuations in the price of the security sold short. Such authority would be
utilized only in furtherance of the Fund's primary investment objective to seek
long-term capital growth.
For federal income tax purposes, a short sale is not considered a completed
transaction until the Fund discharges its obligation by delivering the
securities sold. Thus, if the Fund should sell securities short "against the
box" in December and deliver the securities in January, any capital gain or loss
on the transaction would be realized in January. This principle possibly could
be utilized by the Fund to postpone recognition of capital gain or loss. Special
tax rules prevent conversion of short-term capital gains into long-term capital
gains and, in effect, long-term capital losses into short-term capital losses by
selling short "against the box."
Repurchase Agreements. The Fund pays for repurchase agreements only upon
physical delivery or evidence of book entry transfer of the underlying debt
security to a segregated account of State Street Bank and Trust Company
("Bank"), the Fund's custodian, or its agent. The Fund only enters into
repurchase agreements involving securities in which the Fund can otherwise
invest. The underlying security (normally a security of the U.S. Government, its
agencies or instrumentalities) may have a maturity date exceeding one year.
Repurchase agreements usually mature not more than seven days after purchase by
the Fund. It is the Fund's policy that the market value of the security
collateralizing the repurchase agreement at all times equal or exceed the amount
of the repurchase agreement. The Fund does not bear the risk of a decline in
value of the underlying security unless the seller defaults under its repurchase
obligation. In the event of bankruptcy or other default of a seller, the Fund
might experience both loss and delay in liquidating the underlying security,
including: (a) possible decline in the value of such security while the Fund
seeks to enforce its rights thereto, (b) possible lack of access to income on
such security during this period and (c) expenses of enforcing its rights.
Rule 144A and Other Restricted Securities. The Fund may invest up to 5% of its
net assets in Rule 144A securities. Rule 144A was adopted under the Securities
Act of 1933 (the "1933 Act") to allow a broader institutional trading market for
securities subject to restriction on resale to the general public. The Rule
provides a "safe harbor" for the resale of certain restricted securities among
6
<PAGE> 24
qualified institutional investors without registration under the 1933 Act. The
Fund may also invest up to 5% of its net assets in other securities subject to
legal or contractual restrictions on resale. Such restricted securities
generally may be resold only in a privately negotiated transaction with a
limited number of purchasers or in a public offering registered under the 1933
Act. Considerable delay could be encountered in either event. These difficulties
and delays could result in the Fund's inability to realize a favorable price
upon disposition of restricted securities, and in some cases may make
disposition of such restricted securities at the time desired by the Fund
impossible.
RATINGS
Debt Security Ratings. Moody's Investor Services, Inc. ("Moody's") and Standard
& Poor's Corporation ("S&P") employ the designations set forth below to rate
debt securities.
MOODY'S
Aaa - Bonds judged to be of the best quality. They carry the smallest degree of
investment risk and are generally referred to as gilt-edge. Interest payments
are protected by a large or an exceptionally stable margin and principal is
secure. While the various protective elements are likely to change, such changes
as can be visualized are most unlikely to impair the fundamentally strong
position of such issues.
Aa - Bonds judged to be of high quality by all standards. Together with the Aaa
group they comprise what are generally known as high-grade bonds. They are rated
lower than the best bonds because margins of protection may not be as large as
in Aaa securities, fluctuation of protective elements may be of greater
amplitude, or there may be other elements present which make the long-term risks
appear somewhat larger.
A - Bonds which possess many favorable investment attributes and are to be
considered as upper medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment some time in the future.
Baa - Bonds considered as medium-grade obligations (i.e., they are neither
highly protected nor poorly secured). Interest payments and principal security
appear adequate for the present but certain protective elements may be lacking
or may be characteristically unreliable over any great length of time. Such
bonds lack outstanding investment characteristics and, in fact, have speculative
characteristics as well.
Ba - Bonds judged to have speculative elements. Their future cannot be
considered as well assured. Often the protection of interest and principal
payments may be very moderate and thereby not well safeguarded during other good
and bad times over the future. Uncertainty of position characterizes bonds in
this class.
B - Bonds which generally lack characteristics of the desirable investment.
Assurance of interest and principal payments or of maintenance of other terms of
the contract over any long period of time may be small.
7
<PAGE> 25
Caa - Bonds of poor standing. Such issues may be in default or there may be
present elements of danger with respect to principal or interest.
Ca - Bonds which represent obligations which are speculative in a high degree.
Such issues are often in default or have other marked shortcomings.
C - The lowest rated class of bonds and issues so rated can be regarded as
having extremely poor prospects of ever attaining any real investment standing.
Nonrated - Where no rating has been assigned or where a rating has been
suspended or withdrawn, it may be for reasons unrelated to the quality of the
issue.
Should no rating be assigned, the reason may be one of the following:
1. An application for rating was not received or accepted.
2. The issue or issuer belongs to a group of securities that are not rated as a
matter policy.
3. There is a lack of essential data pertaining to the issue or issuer.
4. The issue was privately placed, in which case the rating is not published in
Moody's publications.
Suspension or withdrawal may occur if new and material circumstances arise, the
effects of which preclude satisfactory analysis; if there is no longer available
reasonable up-to-date data to permit a judgment to be formed; if a bond is
called for redemption; or for other reasons.
Note: Those bonds in the Aa, A, Baa, Ba and B groups which Moody's believe
possess the strongest investment attributes are designated by the symbols Aa 1,
A 1, Baa 1, Ba 1 and B 1.
S&P
AAA - Capacity to pay interest and repay principal is extremely strong.
AA - Capacity to pay interest and repay principal is very strong and these bonds
differ from AAA issues only in small degree.
A - Capacity to pay interest and repay principal is strong although they are
somewhat more susceptible to the adverse effects of changes in circumstances and
economic conditions than bonds in higher rated categories.
BBB - Capacity to pay interest and repay principal is adequate. Whereas these
bonds normally exhibit adequate protection parameters, adverse economic
conditions or changing circumstances are
8
<PAGE> 26
more likely to lead to a weakened capacity to pay interest and repay principal
than for bonds in higher rated categories.
BB, B, CCC, CC, C - Debt rated BB, B, CCC, CC and C is regarded, on balance as
predominantly speculative with respect to capacity to pay interest and repay
principal in accordance with the terms of the obligations. BB indicates the
lowest degree of speculation and C the highest degree of speculation. While such
debt will likely have some quality and protective characteristics, these are
outweighed by large uncertainties or major risk exposures to adverse conditions.
CI - reserved for income bonds on which no interest is being paid.
D - in default, and payment of interest and/or repayment of principal is in
arrears.
Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified by the
addition of a plus or minus sign to show relative standing within the major
rating categories.
NR: Indicates that no rating has been requested, that there is insufficient
information on which to base a rating, or that Standard & Poor's does not rate a
particular type of obligation as a matter of policy.
Commercial Paper Ratings. Moody's and S&P employ the designations set forth
below to rate commercial paper.
Moody's designations, all judged to be investment grade, indicate the relative
repayment capacity of rated issuers. Issuers rated Prime-1 have a superior
capacity for repayment of short-term promissory obligations. Issuers rated
Prime-2 have a strong capacity for repayment of short-term promissory
obligations. Issuers rated Prime-3 have an acceptable capacity for repayment of
short-term promissory obligations.
S&P ratings are an assessment of the likelihood of timely payment of debt having
an original maturity of no more than 365 days. Issuers assigned the highest
rating by S&P ("A") are regarded as having the greatest capacity for timely
payment. Issuers in this category are further refined with the designations 1, 2
and 3 to indicate the relative degree of safety. A-1 indicates that the degree
of safety regarding timely payment is either overwhelming (denoted with a plus
sign) or very strong. A-2 indicates that capacity for timely payment is strong;
however, the relative degree of safety is not as high as for issuers designated
A-1. A-3 indicates a satisfactory capacity for timely payment. They are,
however, somewhat more vulnerable to the adverse effects of changes in
circumstances than obligations carrying the higher designations.
RISK FACTORS RELATING TO LOWER RATED SECURITIES
As described in the Prospectus, the Fund may invest up to 15% of its assets in
convertible securities and other fixed-income securities which are not rated in
the four highest categories by Moody's and S&P. Ratings of debt securities are
described above. The Prospectus discussion of the risks of investing in lower
rated high yield bonds is supplemented as follows:
9
<PAGE> 27
1. Youth and Growth of the High Yield Bond Market. Since the high yield bond
market is relatively new, its growth has paralleled a long economic
expansion, and it has not weathered a lengthy recession in its present size
and form. An economic downturn or increase in interest rates is likely to
have a negative effect on the high yield bond market and on the value of the
high yield bonds in the Fund's portfolio, as well as on the ability of the
bonds' issuers to repay principal and interest.
2. Sensitivity to Interest Rate and Economic Changes. The economy and interest
rates affect high yield securities differently from other securities. The
prices of high yield bonds have been found to be less sensitive to interest
rate changes than higher rated investments, but more sensitive to adverse
economic changes or individual issuer developments. During an economic
downturn or substantial period of rising interest rates, highly leveraged
issuers are likely to experience financial stress which would adversely
affect their ability to service their principal and interest payment
obligations, to meet projected business goals, and to obtain additional
financing. If the issuer of a bond owned by the Fund defaults, the Fund may
incur additional expenses to seek recovery. In addition, periods of economic
uncertainty and changes can be expected to result in increased volatility of
market prices of high yield bonds and the Fund's asset value. Furthermore, in
the case of high yield bonds structured as zero coupon or pay-in-kind
securities, their market prices are affected to a greater extent by interest
rate changes and thereby tend to be more volatile than securities which pay
interest periodically and in cash.
3. Liquidity and Valuation. To the extent that there is no established retail
secondary market, there may be thin trading of high yield bonds, and there
may be a negative impact on the Fund's Board of Directors' ability to
accurately value high yield bonds and the Fund's assets and on the Fund's
ability to dispose of the bonds. Adverse publicity and investor perceptions,
whether or not based on fundamental analysis, may decrease the values and
liquidity of high yield bonds, especially in a thinly traded market. To the
extent the Fund owns or may acquire illiquid high yield bonds, these
securities may involve special liquidity and valuation difficulties.
4. Legislation. New laws and proposed new laws may have a negative impact on the
market for high yield bonds. For example, recent legislation requires
federally-insured savings and loan associations to divest their investments
in high yield bonds.
5. Taxation. Special tax considerations are associated with investing in high
yield bonds structured as zero coupon or pay-in-kind securities. The Fund
accrues the interest on these securities as income even though it receives no
cash interest until the security's maturity or payment date. The Fund is
required to distribute such income to its shareholders in order to maintain
its qualification for pass-through treatment under the Internal Revenue Code.
Thus, the Fund may have to dispose of portfolio securities at a time it
otherwise might not want to do so in order to provide the cash necessary to
make distributions to those shareholders who do not reinvest dividends.
6. Credit Ratings. Certain risks are associated with applying credit ratings as
a method of evaluating high yield bonds. Credit ratings evaluate the safety
of principal and interest payments, not market value risk of high yield
bonds. Since credit rating agencies may fail to timely change the credit
ratings to reflect subsequent events, the Adviser monitors the issuers of
high yield bonds in the Fund's portfolio to determine if the issuers appear
to have sufficient
10
<PAGE> 28
cash flow to meet required principal and interest payments. The Fund may
retain a portfolio security whose rating has been changed.
INVESTMENT RESTRICTIONS
The Fund has adopted the investment restrictions set forth below, which apply at
the time securities are purchased or other relevant action is taken. These
restrictions and the Fund's investment objective cannot be changed without
approval of the holders of a majority of outstanding Fund shares. Such majority
is defined in the Investment Company Act of 1940 ("Investment Company Act") as
the lesser of (a) 67% or more of the voting securities present in person or
represented by proxy at a meeting, if the holders of more than 50% of the
outstanding voting securities are present or represented by proxy; or (b) more
than 50% of the outstanding voting securities. Percentage limitations applicable
to investments are calculated and applied at the time of investment. In addition
to those described in the Prospectus, these restrictions provide that the Fund
shall not:
1. Issue any class of senior security nor sell any senior security of which it
is the issuer, except that the Fund is permitted to borrow from any bank;
provided that such borrowing may only be as a temporary measure for
extraordinary or emergency purposes, but not for investment purposes and
shall not, in the aggregate, exceed 10% of its total assets taken at cost or
5% of its total assets taken at current value, whichever is less; and
provided that immediately after such borrowing, there is an asset coverage of
at least 300% for all borrowings of the Fund;
2. Underwrite the sale of any securities other than Fund shares;
3. Purchase or sell commodities, commodity contracts or real estate;
4. Lend money or securities to any person, firm, or corporation for any purpose
whatsoever; provided, however, that the following are not construed as the
making of a loan: (a) the acquisition of a portion of publicly distributed
bonds, debentures, notes and other obligations or evidence of interest in or
indebtedness of any corporation, domestic or foreign, or of any government or
municipality; (b) the acquisition of obligations of, or obligations
guaranteed by, national or state banks or bank holding companies (including
certificates of deposit and bankers acceptances); and (c) the entry into
repurchase agreements if the following conditions are met: (1) that the
securities or instruments subject to the agreement are of the type in which
the Fund may otherwise invest, (2) that at the time the repurchase agreement
is made the value of the securities or instruments involved is equal to the
purchase price, (3) that not more than 20% of the Fund's total assets, at the
time the agreement is made, will be invested pursuant to such agreements, and
(4) that such agreements with any one entity, together with any other
investments in that entity, shall not exceed in the aggregate 5% of the
Fund's total assets, at market value, computed at the time the agreement is
made;
5. Mortgage, pledge, hypothecate or in any manner transfer, as security for any
indebtedness, any security owned or held by the Fund;
6. Participate on a joint or a joint and several basis in any trading account in
securities;
7. Purchase from or sell to any officer or director of the Fund, or firms of
which any of them are members, any securities other than Fund shares; but
such persons or firms may act as brokers for the Fund for customary
commissions;
11
<PAGE> 29
8. Purchase or retain any securities of any issuer if those officers and
directors of the Fund or of its manager or investment adviser owning
individually more than 0.5% of the securities of such issuer together own
beneficially more than 5% of the securities of such issuer;
9. Invest for the purpose of exercising control over or management of any
company;
10. Invest in securities issued by other investment companies;
11. Effect short sales of securities, except that the Fund may make certain
short sales of securities or maintain a short position if the Fund
contemporaneously owns or has the right to obtain at no added cost
securities identical to those sold short (short sales "against the box") or
if the securities sold are "when issued" or "when distributed" securities
which the Fund expects to receive in a recapitalization, reorganization, or
other exchange for securities the Fund contemporaneously owns or has the
right to obtain at no added cost;
12. Buy securities on margin;
13. Purchase or sell securities other than Fund shares through any brokerage or
investment organization in which any officer or director of the Fund is a
partner, officer, director or shareholder;
14. Invest more than 5% of its assets in securities of corporations which have a
record of less than three years continuous operation; or
15. Write options, except the Fund may write covered call options and effect
closing transactions; provided the Fund shall: (i) write options only on
securities which it owns and which are traded on a national securities
exchange; (ii) retain ownership of the underlying security for the duration
of said options and (iii) not write any option which would, at the time,
cause outstanding options written by the Fund to cover securities comprising
more than 10% of the value of the Fund's assets.
Additional Restrictions. The Fund is also subject to the policies set forth
below which its Board of Directors may amend and which apply at the time of
purchase of securities. These restrictions provide that the Fund shall not:
1. Invest more than 10% of total net assets in repurchase agreements with
maturities over seven days and/or other securities which are not readily
marketable;
2. Purchase warrants exceeding 2% of total assets;
3. Invest in oil, gas or other mineral exploration or development programs; or
4. Purchase Rule 144A securities in an amount exceeding 5% of the Fund's net
assets or purchase other securities subject to legal or contractual
restrictions on resale in an amount exceeding 5% of the Fund's net assets.
12
<PAGE> 30
DIRECTORS AND OFFICERS OF THE FUND
All directors and officers of the Fund are also directors and/or officers of one
or more of the four other investment companies advised by the Adviser, which is
an indirect wholly owned subsidiary of United Asset Management Corporation
("UAM"). These investment companies are FPA New Income, Inc. ("New Income"), FPA
Paramount Fund, Inc. ("Paramount"), FPA Perennial Fund, Inc. ("Perennial") and
Source Capital, Inc. ("Source") (collectively, the "FPA Fund Complex").
The directors and officers of the Fund and their principal occupations during
the past five years follow. Their address is 11400 West Olympic Boulevard, Suite
1200, Los Angeles, California 90064.
Donald E. Cantlay, Director
General Partner of Cee'n'Tee Co. (commercial real estate) for more than the past
five years. Director of New Income, of Transamerica Income Shares, Inc. ("Income
Shares"), of California Trucking Association and of Western Highway Institute.
Member of the Board of Regents of Loyola Marymount University.
DeWayne W. Moore, Director
Former Director, Senior Vice President and Chief Financial Officer of Guy F.
Atkinson Company of California (construction). Director of New Income and of
Income Shares.
Lawrence J. Sheehan, Director (1)
Of counsel to, and partner (1969 to 1994) of, the law firm of O'Melveny & Myers
LLP, legal counsel to the Fund. Director of Source, of Perennial and of New
Income. Director of TCW Convertible Securities Fund, Inc., a closed-end
investment company.
Kenneth L. Trefftzs, Director
Private investor. Former Professor of Finance and Chairman of the Department of
Finance and Business Economics, University of Southern California Graduate
School of Business. Director of Source, of Perennial, of New Income and of
Fremont General Corporation (financial service company). Director (or Trustee)
of the Pacific Horizon Funds and Horizon Funds, a group of 13 open-end
investment company portfolios.
Robert L. Rodriguez, President & Chief Investment Officer
Director, Principal and Chief Investment Officer of the Adviser since March
1996; President and Chief Investment Officer of New Income for more than the
past five years; and Director and Senior Vice President of Source since March
1996. Director of the Distributor since March 1996. Executive Vice President
from January 1996 to March 1996, Senior Vice President from February 1993 to
January 1996, and Vice President from November 1983 to February 1993, of the
Adviser.
13
<PAGE> 31
Christopher Linden, Senior Vice President
Director and Principal of the Adviser since March 1996, and Senior Vice
President of New Income, of Paramount, of Perennial and of Source for more than
the past five years. President from February 1993 to March 1996, Senior Vice
President from November 1980 to February 1993, and Director and Chief Operating
Officer from June 1991 to September 1995, of the Adviser; Director and Chairman
of the Board from June 1985 to May 1995, and Chief Operating Officer from
December 1982 to November 1995, of Paramount; President and Chief Investment
Officer of Perennial from September 1983 to September 1995; and Director of the
Distributor from May 1991 to September 1995.
Eric S. Ende, Vice President
Senior Vice President (or Vice President) of the Adviser and of Source for more
than the past five years; President and Chief Investment Officer of Perennial
since September 1995; and Vice President of New Income and of Paramount for more
than the past five years. Executive Vice President of Perennial from August 1995
to September 1995, and Vice President of Perennial from May 1985 to August 1995.
Julio J. de Puzo, Jr., Treasurer
Director (since October 1995), Principal (since March 1996) and Chief Executive
Officer (since March 1996) of the Adviser; Director (since March 1996),
President (since March 1996) and Treasurer for more than the past five years of
Source; Director (since April 1996), Executive Vice President (since April 1996)
and Treasurer for more than the past five years of Paramount and of Perennial;
and Treasurer of New Income for more than the past five years. Executive Vice
President (since March 1996), Chief Financial Officer (since October 1991) and
Director for more than the past five years of the Distributor. Executive Vice
President from October 1995 to March 1996, Chief Administrative Officer from
October 1995 to March 1996, Chief Financial Officer from June 1991 to March
1996, Treasurer from June 1991 to March 1996, Senior Vice President from
February 1993 to October 1995, and First Vice President from April 1985 to
February 1993, of the Adviser; and Senior Vice President (or First Vice
President) from October 1991 to March 1996 of the Distributor.
Sherry Sasaki, Secretary
Assistant Vice President (since December 1992) and Secretary for more than the
past five years of the Adviser; and Secretary of Source, of New Income, of
Paramount and of Perennial for more than the past five years. Secretary for more
than the past five years of the Distributor.
Christopher H. Thomas, Assistant Treasurer
Vice President and Controller of the Adviser and of the Distributor since March
1995, and Assistant Treasurer of Capital, of New Income, of Source and of
Paramount since April 1995. Staff Accountant with the Office of Inspection of
the Securities and Exchange Commission from 1994 to March 1995. School
Administrator of the Calvary Road Christian Academy from 1988 to 1993.
- --------------------------
(1) Director who is an interested person, as defined in the Investment Company
Act, by virtue of his affiliation with legal counsel to the Fund, in the
case of Mr. Sheehan.
14
<PAGE> 32
The Directors and officers of the Fund as a group own less than 1% of the
outstanding Fund shares. During the last fiscal year, the Directors then in
office who were not affiliated with the Adviser received as a group $19,500 in
Directors' fees. Such Directors were also reimbursed for certain travel expenses
by the Fund. The following information relates to Director compensation. The
Fund does not pay any salaries to its officers, all of whom are compensated by
the Adviser.
<TABLE>
<CAPTION>
TOTAL COMPENSATION*
AGGREGATE COMPENSATION* FROM THE FPA FUND COMPLEX
NAME OF DIRECTORS FROM THE FUND INCLUDING THE FUND
- ----------------- ------------- ------------------
<S> <C> <C>
Donald E. Cantlay 5,000 10,000**
DeWayne W. Moore 4,500 9,500**
Lawrence J. Sheehan 5,000 30,750***
Kenneth L. Trefftzs 5,000 30,750***
</TABLE>
* No pension or retirement benefits are provided to Directors by the Fund or
the FPA Fund Complex.
** Includes compensation from the Fund and one other open-end investment
company.
*** Includes compensation from the Fund, two other open-end investment
companies, and one closed-end investment company.
Currently, the personnel of the Adviser consists of seven persons engaged full
time in portfolio management or investment research in addition to 26 persons
engaged full time in trading, administrative, financial or clerical activities.
The Adviser is registered as an investment adviser with the Securities and
Exchange Commission, which does not imply supervision by said Commission of the
Adviser's activities. The Adviser's parent company, UAM, is a publicly held
corporation. No person is known by UAM to own or hold with power to vote 25% or
more of its outstanding shares of common stock.
Five Percent Shareholders. As of June 30, 1996, no person was known by the Fund
to own of record or beneficially 5% or more of the outstanding Fund shares,
except ICMA Retirement Trust dated 12/31/83, 777 North Capitol Street, N.E.,
Suite 600, Washington, D.C., 20002-4239, which held 1,017,010 shares (6.65%) of
the outstanding Fund shares.
INVESTMENT ADVISORY AGREEMENT
The Fund has entered into an Investment Advisory Agreement dated August 1, 1994
("Advisory Agreement") with the Adviser pursuant to which the Adviser provides
continuing supervision of the Fund's investment portfolio. The Adviser is
authorized, subject to the control of the Fund's Board of Directors, to
determine which securities are to be bought or sold and in what amounts. In
addition to providing investment advisory and management services, the Adviser
furnishes office space, facilities and equipment, and maintains the Fund's books
and records. It also compensates all officers and other personnel of the Fund,
all of whom are employed by the Adviser, subject to
15
<PAGE> 33
reimbursement from the Fund for personnel involved in providing financial
services as indicated below.
Other than the expenses the Adviser specifically assumes under the Advisory
Agreement, the Fund bears all costs of its operation. These costs include the
charges and expenses of any custodian or depository appointed by the Fund for
the safekeeping of its cash, portfolio securities and other property; the
charges and expenses of auditors; the charges and expenses of any stock transfer
or dividend agent or agents appointed by the Fund; brokers' commissions
chargeable to the Fund in connection with portfolio securities transactions to
which the Fund is a party; all taxes, including issuance and transfer taxes, and
corporate fees payable by the Fund to federal, state or other governmental
agencies; the cost of stock certificates representing Fund shares; fees involved
in registering and maintaining registrations of the Fund and of Fund shares with
the Securities and Exchange Commission ("SEC") and various states and other
jurisdictions; all expenses of shareholders' and directors' meetings and of
preparing, printing and mailing proxy statements and semi-annual and annual
reports to shareholders except as set forth in the Distribution Agreement
between the Fund and the Distributor; fees and travel expenses of independent
and unaffiliated directors; the expense of furnishing, or causing to be
furnished, to all shareholders a statement of account after every transaction
affecting their account, including the expense of mailing; charges and expenses
of legal counsel in connection with matters relating to the Fund, including,
without limitation, legal services rendered in connection with the Fund's
corporate and financial structure and relations with its shareholders, issuance
of Fund shares, and registrations and qualifications of securities under
federal, state and other laws; association dues; interest payable on Fund
borrowings; postage; and reimbursement of the Adviser's expenses in providing
financial services to the Fund as described below.
For services rendered, the Adviser is paid a monthly fee computed at the annual
rate of 0.75% of the first $50 million, and 0.65% of the excess over $50
million, of the Fund's average net assets. The advisory fee is higher than the
fee paid by some other mutual funds. The average net assets are determined by
taking the average of all the daily determinations of net assets made, in the
manner provided in the Fund's Articles of Incorporation, during a calendar
month.
In addition to the advisory fee, the Fund reimburses the Adviser monthly for
costs incurred in providing financial services to the Fund. Such financial
services include (a) maintaining the accounts, books and other documents which
constitute the record forming the basis for the Fund's financial statements, (b)
preparing such financial statements and other Fund documents and reports of a
financial nature required by federal and state laws, (c) calculating daily net
assets and (d) participating in the production of the Fund's registration
statements, prospectuses, proxy materials and reports to shareholders (including
compensation of the Treasurer or other principal financial officer of the Fund,
compensation of personnel working under such person's direction and expenses of
office space, facilities and equipment such persons use to perform their
financial services duties). However, for any fiscal year, the cost of such
financial services paid by the Fund may not exceed 0.10% of the average daily
net assets of the Fund.
The advisory fee and cost of financial services is reduced in the amount by
which certain defined operating expenses of the Fund (including the advisory fee
and cost of financial services) for any fiscal year exceed 1.50% of the first
$30 million of average net assets, plus 1% of the remaining
16
<PAGE> 34
average net assets. Such values are calculated at the close of business on the
last business day of each calendar month. Any required reduction or refund is
computed and paid monthly. Operating expenses (as defined in the Advisory
Agreement) exclude (a) interest, (b) taxes, (c) brokerage commissions and (d)
any extraordinary expenses, such as litigation, merger, reorganization or
recapitalization, to the extent such extraordinary expenses are permitted to be
excluded by the rules or policies of the states in which Fund shares are
registered for sale. All expenditures, including costs connected with the
purchase, retention or sale of portfolio securities, which are capitalized in
accordance with generally accepted accounting principles applicable to
investment companies, are accounted for as capital items and not as expenses.
This expense limitation provision does not require any payment by the Adviser
beyond the return of the advisory fee and cost of financial services paid to it
by the Fund for a fiscal year.
The Advisory Agreement provides that the Adviser does not have any liability to
the Fund or any of its shareholders for any error of judgment, any mistake of
law or any loss the Fund suffers in connection with matters related to the
Advisory Agreement, except for liability resulting from willful misfeasance, bad
faith or negligence on the part of the Adviser or the reckless disregard of its
duties under the Advisory Agreement.
The Advisory Agreement is renewable annually if such renewal is specifically
approved each year (a) by the Fund's Board of Directors or by the vote of a
majority of the Fund's outstanding voting securities and (b) by the vote of a
majority of the Fund's directors who are not parties to the Advisory Agreement
or interested persons (as defined in the Investment Company Act) of any such
party, by votes cast in person at a meeting called for the purpose of voting on
such approval. The continuation of the Advisory Agreement to September 30, 1997,
has been approved by the Board of Directors and a majority of the Fund's
directors who are not parties to the Advisory Agreement or interested persons of
any such party (as defined in the Investment Company Act). The Advisory
Agreement may be terminated without penalty upon 60 days' written notice at the
option of either party or by the vote of the Fund's shareholders. The Advisory
Agreement automatically terminates in the event of its assignment.
For the fiscal years ended March 31, 1994, 1995 and 1996, the Adviser received
gross advisory fees of $1,006,089, $1,231,401 and $2,244,261, respectively, plus
$147,091, $181,754 and $337,579, respectively, for costs incurred in providing
financial services to the Fund.
PRIOR PERFORMANCE INFORMATION
For the purposes of quoting and comparing the performance of the Fund to that of
other mutual funds and to other relevant market indices in advertisements,
performance may be stated in terms of total return. Under regulations adopted by
the Securities and Exchange Commission ("SEC"), funds that intend to advertise
performance must include total return quotations calculated according to the
following formula:
17
<PAGE> 35
P(1 + T)n = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years (1, 5 or 10)
ERV = ending redeemable value of a hypothetical
$1,000 payment, made at the beginning of the 1, 5 or
10 year period, at the end of such period (or
fractional portion thereof).
Under the foregoing formula, the time periods used in advertising will be based
on rolling calendar quarters, updated to the last day of the most recent quarter
prior to submission of the advertising for publication, and will cover 1, 5 and
10 year periods of a fund's existence or such shorter period dating from the
effectiveness of a fund's Registration Statement. In calculating the ending
redeemable value, the maximum sales load is deducted from the initial $1,000
payment and all dividends and distributions by a fund are assumed to have been
reinvested at net asset value as described in the Prospectus on the reinvestment
dates during the period. Total return, or "T" in the formula above, is computed
by finding the average annual compounded rates of return over the 1, 5 and 10
year periods (or fractional portion thereof) that would equate the initial
amount invested to the ending redeemable value.
The Fund may also from time to time include in such advertising a total return
figure that is not calculated according to the formula set forth above in order
to compare the performance of the Fund with other measures of investment return.
For example, in comparing the Fund's total return with a stock index such as the
Standard & Poor's 500 Stock Index, the Fund calculates its aggregate total
return for the specified periods of time by assuming the investment of $10,000
in Fund shares and assuming the reinvestment of each dividend or other
distribution at net asset value on the reinvestment date. Percentage increases
are determined by subtracting the initial value of the investment from the
ending value and by dividing the remainder by the beginning value. The Fund does
not, for these purposes, deduct from the initial value invested any amount
representing sales charges. The Fund, however, discloses the maximum sales
charge and also discloses that inclusion of sales charges would reduce the
performance quoted. Such alternative total return information will be given no
greater prominence in such advertising than the information prescribed under SEC
regulations.
The Fund's average annual total return (calculated in accordance with the SEC
regulations described above) for the one, five and ten-year periods ended March
31, 1996 was 27.95%, 21.52% and 17.48%, respectively. The Fund's average annual
total return (determined pursuant to the alternative computation which does not
include the maximum initial sales charge of 6.5% of the offering price) for the
same periods was 36.84%, 23.16% and 18.27%, respectively. These results are
based on historical earnings and asset value fluctuations and are not intended
to indicate future performance.
The foregoing information should be considered in light of the Fund's investment
objectives and policies, as well as the risks incurred in the Fund's investment
practices. Future results will be affected by the future composition of the
Fund's portfolio, as well as by changes in the general price
18
<PAGE> 36
level of equity securities, and general economic and other market conditions.
The past 1, 5 and 10 year periods have been ones of generally rising common
stock prices subject to short-term fluctuations.
PORTFOLIO TRANSACTIONS AND BROKERAGE
The Adviser makes decisions to buy and sell securities for the Fund, selects
broker-dealers and negotiates commission rates or net prices. In
over-the-counter transactions, orders are placed directly with a principal
market maker unless it is believed better prices and executions are available
elsewhere. Portfolio transactions are effected with broker-dealers selected for
their abilities to give prompt execution at prices favorable to the Fund. In
selecting broker-dealers and in negotiating commissions, the Adviser considers:
the best net price available; each firm's reliability, integrity and financial
condition; the size of and difficulty in executing the order; and the value of
the firm's expected contribution to the Fund's investment performance on a
continuing basis. Accordingly, the net price to the Fund in any transaction may
be less favorable than that available from another broker-dealer if the
difference is reasonably justified by other aspects of its services. Subject to
policies determined by the Fund's Board of Directors, the Adviser shall not be
deemed to have acted unlawfully or to have breached any duty created by the
Advisory Agreement or otherwise solely because the Fund paid a broker-dealer
providing brokerage and research services commissions for effecting a
transaction in excess of the commission another broker-dealer would have charged
for the same transaction. The Adviser must determine in good faith that such
commission was reasonable relative to the value of the brokerage and research
services provided, considering either that particular transaction or the
Adviser's overall responsibilities to the Fund. The Adviser is further
authorized to allocate orders it places for the Fund to broker-dealers providing
products or services which assist in making investment decisions. The Adviser
shall allocate the amounts and proportions of such costs and shall regularly
report on such allocations to the Fund's Board of Directors.
Brokerage and research services are defined by Section 28(e) of the Securities
Exchange Act of 1934 to include (a) providing advice as to the value of
securities, the advisability of investing in, purchasing or selling securities,
and the availability of securities or purchasers or sellers of securities; (b)
furnishing analyses and reports concerning issuers, industries, securities,
economic factors and trends, portfolio strategy and performance of accounts; and
(c) effecting securities transactions and performing functions incidental
thereto, such as clearance, settlement and custody.
Research services furnished by broker-dealers effecting securities transactions
for the Fund may be used by the Adviser for all advisory accounts. However, the
Adviser may not use all such research services in managing the Fund's portfolio.
In the opinion of the Adviser, it is not possible to measure separately the
benefits from research services to each advisory account. Because the volume and
nature of the trading activities of advisory accounts are not uniform, the
amount of commissions in excess of the lowest available rate paid by each
advisory account for brokerage and research services will vary. However, the
Adviser believes the total commissions the Fund pays are not disproportionate to
the benefits it receives on a continuing basis.
The Adviser attempts to allocate portfolio transactions equitably whenever
concurrent decisions are made to purchase or sell securities for the Fund and
another advisory account. In some cases, this
19
<PAGE> 37
procedure could have an adverse effect on the price or amount of securities
available to the Fund. The main factors considered in such allocations are the
respective investment objectives, the relative amount of portfolio holdings of
the same or comparable securities, the availability of cash for investment, the
size of investment commitments generally held, and the opinion of the persons
responsible for recommending the investments.
Brokerage commissions paid by the Fund on portfolio transactions for the fiscal
years ended March 31, 1994, 1995 and 1996 totaled $107,570, $67,585 and
$187,464, respectively. During the last fiscal year, $181,504 of commissions
were paid on transactions having a total value of $75,318,281 to brokers
selected because of research services provided to the Adviser.
PORTFOLIO TURNOVER
The portfolio turnover rate is calculated by dividing the lesser of purchases or
sales of portfolio securities for a fiscal year by the average monthly value of
the portfolio securities during such fiscal year. Securities maturing in one
year or less at the time of acquisition are not included in this computation.
The turnover rate for prior periods is shown in the Prospectus under the caption
"Financial Highlights." This rate may vary greatly from year to year as well as
within a year.
DISTRIBUTOR
FPA Fund Distributors Inc., a wholly owned subsidiary of the Adviser, acts as
the principal underwriter of Fund shares pursuant to a distribution agreement
dated August 1, 1994 ("Distribution Agreement"). The Distributor receives
commissions from the sale of Fund shares and has the exclusive right to
distribute Fund shares through dealers. From commissions received, the
Distributor pays its own overhead and general administrative expenses, the cost
of printing and distributing prospectuses used in connection with this offering,
except for those furnished to existing shareholders, and the cost of advertising
and sales literature. The Fund pays expenses attributable to the registration of
Fund shares under federal and state laws and the compensation and expenses of
the Fund's transfer agent.
The Distribution Agreement is renewable annually if such renewal is specifically
approved each year (a) by the Fund's Board of Directors or by a vote of a
majority (as defined in the Investment Company Act) of the Fund's outstanding
voting securities and (b) by a majority of the Fund's directors who are not
parties to the Distribution Agreement or interested persons (as defined in the
Investment Company Act) of any such party, by votes cast in person at a meeting
called for such purpose. The continuation of the Distribution Agreement to
September 3, 1997, has been approved by the Board of Directors and a majority of
the Fund's directors who are not parties to the Distribution Agreement or
interested persons of any such party (as defined in the Investment Company Act).
The Distribution Agreement terminates if assigned (as defined in the Investment
Company Act) and may be terminated at any time on 60 days' written notice,
without penalty, by the Fund's Board of Directors, the vote of a majority of the
Fund's outstanding voting securities or the Distributor.
20
<PAGE> 38
The Distributor's obligation under the Distribution Agreement is an agency or
best efforts arrangement pursuant to which the Distributor is required to take
and pay for only those Fund shares sold to the public. The Distributor is not
obligated to sell any stated number of Fund shares.
For the fiscal years ended March 31, 1994, 1995 and 1996, underwriting
commissions on the sale of Fund shares were $373,464, $1,510,397 and $2,287,783,
respectively. Of such totals, the amount retained each year by the Distributor,
after reallowance to other dealers, was $19,504, $68,274 and $127,932,
respectively.
PURCHASE AND REDEMPTION OF SHARES
Net Asset Value. The net asset value is computed as of the close of the New York
Stock Exchange ("NYSE") on each business day during which the NYSE is open. Net
asset value, rounded to the nearest cent per share, is the total market value of
all the Fund's portfolio securities plus other assets (including any accrued
reimbursement of expenses), less all liabilities, divided by the total number of
Fund shares outstanding. The NYSE is closed not only on weekends but also on
customary holidays, which currently are New Year's Day, President's Day, Good
Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and
Christmas Day. Computation is made by valuing (a) securities listed or traded on
a national securities exchange or on the NASDAQ National Market System at the
last sale price or, if there has been no sale that day, at the last bid price,
(b) unlisted securities for which quotations are readily available at the last
representative bid price as supplied by the National Association of Securities
Dealers Automated Quotations (NASDAQ) or by dealers, and (c) securities for
which there are no readily available market quotations and all other assets at
fair value in such manner as determined in good faith by the Fund's Board of
Directors.
Sales Charges. The maximum sales charge is 6.5%, as a percentage of the offering
price, but lower sales charges apply to larger purchases. A portion of the sales
charge is allocated to dealers selling Fund shares in amounts ranging from 80%
to 94%, depending on the size of the investment. During special promotions, the
Distributor may reallow up to 100% of the sales charge to dealers. At such times
dealers may be deemed to be underwriters for purposes of the Securities Act of
1933. Discounts are alike to all dealers.
Sales at Net Asset Value. Full-time employees of the Adviser may purchase Fund
shares at net asset value via payroll deduction, provided the minimum initial
investment is $250. Each subsequent investment must be at least $50.
Letter of Intent. To be eligible, the investor must sign at the time of initial
purchase, or within 30 days, a letter of intent ("LOI") covering investments to
be made within a period of 13 months ("Period") from such initial purchase. The
investor thereby becomes eligible for a reduced sales charge based on the total
amount of the specified intended investment ("LOI Goal"), provided such amount
is not less than $10,000. A minimum initial purchase of $1,500 and minimum
subsequent purchases of $100 each are required. Fund shares may also be
purchased to fulfill a letter of intent entered into with respect to shares of
the other FPA Funds. The account information form, which should be used to
establish an LOI, is available from dealers or the Distributor.
21
<PAGE> 39
All transactions under an LOI must be indicated as such and must be placed by
the dealer (in the case of an initial purchase) or the shareholder (in the case
of any subsequent purchase) directly through Boston Financial Data Services,
Inc. ("Shareholder Service Agent"). Shareholders should review for accuracy all
confirmations of transactions, especially purchases made pursuant to an LOI.
If the LOI Goal is completed before the end of the Period, any subsequent
purchases within the Period receive the reduced sales charge applicable. In
addition, during the Period, the shareholder may increase his or her LOI Goal
and all subsequent purchases are treated as a new LOI (including escrow of
additional Fund shares) except as to the Period, which does not change.
Signing an LOI does not bind the shareholder to complete his or her LOI Goal,
but the LOI Goal must be completed to obtain the reduced sales charge. The LOI
is binding on the Fund and the Distributor. However, the Distributor may
withdraw a shareholder's LOI privileges for future purchases upon receiving
information that the shareholder has resold or transferred his or her Fund
shares within the Period.
The LOI requires the Shareholder Service Agent, as escrow agent, to hold 5% of
the LOI Goal in escrow until completion of the LOI Goal within the Period. The
escrowed Fund shares are taken from the first purchase and, if necessary, from
each successive purchase. If the LOI Goal is completed within the Period, the
escrowed Fund shares are promptly delivered to, or as directed by, the
shareholder.
If the LOI Goal is not completed within the Period, the shareholder must pay the
Distributor an amount equal to the sales charge applicable to a single purchase
in the total amount of the purchases made under the LOI minus the sales charges
actually paid. If the Distributor does not receive such unpaid sales charge
within 20 days after requesting payment in writing, the Distributor instructs
the Shareholder Service Agent to redeem escrowed Fund shares sufficient to cover
the unpaid sales charge. Under the LOI, the shareholder irrevocably appoints the
Shareholder Service Agent as his or her attorney with full power of substitution
in the premises to surrender for redemption any or all escrowed Fund shares. If
the redemption proceeds are inadequate, the shareholder is liable to the
Distributor for the difference. The Shareholder Service Agent delivers to, or as
directed by, the shareholder all Fund shares remaining after such redemption,
together with any excess cash proceeds.
Any income dividends and capital gains distributions on the escrowed Fund shares
are paid to, or as directed by, the shareholder.
FPA Exchange Privilege. The procedures for exchanging shares between FPA Funds
are set forth under "Purchase of Shares - FPA Exchange Privilege" in the Fund's
Prospectus. If the account registration information for the two FPA Fund
accounts involved in the exchange are different in any respect, the exchange
instructions must be in writing and must contain a signature guarantee as
described under "Redemption of Shares" in the Fund's Prospectus.
By use of the exchange privilege, the investor authorizes the Shareholder
Service Agent ("Agent") to act on telephonic, telegraphic or written exchange
instructions from any person representing
22
<PAGE> 40
himself to be the investor or the agent of the investor and believed by the
Agent to be genuine. The Agent's records of such instructions are binding.
For purposes of determining the sales charge rate previously paid, all sales
charges paid on the exchanged security and on any security previously exchanged
for such security or for any of its predecessors shall be included. If the
exchanged security was acquired through reinvestment, that security may be
exchanged without a sales charge. If a shareholder exchanges less than all of
his securities, the security requiring no or the lowest incremental sales charge
is deemed exchanged first.
Exchange requests received on a business day prior to the time shares of the
funds involved in the request are priced, are processed on the date of receipt
by the Shareholder Service Agent. "Processing" a request means that shares in
the Fund from which the shareholder is withdrawing an investment will be
redeemed at the net asset value per share next determined after receipt. Shares
of the new Fund into which the shareholder is investing will also normally be
purchased at the net asset value per share, plus any applicable sales charge,
next determined after receipt by the Shareholder Service Agent. Exchange
requests received on a business day after the time shares of the funds involved
in the request are priced, are processed on the next business day in the manner
described above.
Redemption of Shares. Redemptions are not made on days during which the NYSE is
closed, including those holidays listed under "Purchase and Redemption of Shares
- - Net Asset Value." The right of redemption may be suspended and the payment
therefore may be postponed for more than seven days during any period when (a)
the NYSE is closed for other than customary weekends or holidays; (b) trading on
the NYSE is restricted; (c) an emergency exists as a result of which disposal by
the Fund of securities it owns is not reasonably practicable or it is not
reasonably practical for the Fund to fairly determine the value of its net
assets; or (d) the Securities and Exchange Commission, by order, so permits.
Telephone Redemption. Redemptions may be made by telephone once the shareholder
has properly completed and returned to the Shareholder Service Agent the
optional shareholder services form, including the designation of a bank account
to which the redemption payment is to be sent ("Designated Bank"). The proceeds
will not be mailed or wired to other than the Designated Bank. New investors who
wish to establish the telephone redemption privilege must complete the
appropriate section on the optional shareholder services form. Existing
shareholders who wish to establish the telephone redemption privilege or change
the Designated Bank should either enter the new information on an optional
shareholder services form, marking it for "change of information" purposes, or
send a letter identifying the Fund account and specifying the exact information
to be changed. The letter must be signed exactly as the shareholder's name(s)
appear on the account. All signatures require a guarantee as described under
"Redemption of Shares" in the Fund's Prospectus. The optional shareholder
services form is available from authorized securities dealers or the
Distributor.
Shareholders who want to use a savings and loan ("S&L") as their Designated Bank
are advised that if the S&L is not a participant in the Federal Reserve System,
redemption proceeds must be wired through a commercial bank which is a
correspondent of the S&L. As this may delay receipt by the shareholder's
account, it is suggested that shareholders who wish to use an S&L discuss wire
23
<PAGE> 41
procedures with their S&L and submit any special wire transfer information with
the telephone redemption authorization. If appropriate wire information is not
supplied, redemption proceeds will be mailed to such Designated Bank.
The shareholder may cancel the telephone redemption authorization upon written
notice. If the shareholder has authorized telephone redemptions, neither the
Fund nor the Shareholder Service Agent is responsible for any unauthorized
telephone redemptions. If the Fund shares to be redeemed by telephone
(technically a repurchase by agreement between the Fund and the shareholder)
were recently purchased by check, the Shareholder Service Agent can delay
transmitting the proceeds until the purchasing check has cleared.
TAX SHELTERED RETIREMENT PLANS
Through the Distributor, prototype retirement plans are available for purchase
of Fund shares. These include plans for self-employed individuals and plans for
individuals buying shares under an Individual Retirement Account. The investor
should be aware that a penalty tax applies, in general, to distributions made
before age 59-1/2, excess contributions and failure to commence distribution of
the account at age 70-1/2. Borrowing from or against the account may also result
in plan disqualification. Distributions from these retirement plans generally
are taxable as ordinary income when received.
State Street Bank and Trust Company ("Bank") presently acts as custodian for
retirement plans and imposes fees for administering them. Purchases of Fund
shares for a retirement plan must be made by direct remittance to the Bank.
When contributions for any tax-qualified plan are invested in Fund shares, all
dividends and capital gains distributions paid on those Fund shares are retained
in such plan and automatically reinvested in additional Fund shares at net asset
value. All earnings accumulate tax-free until distribution.
The investor should consult his or her own tax adviser concerning the tax
ramifications of establishment of and distributions from a retirement plan.
DIVIDENDS, DISTRIBUTIONS AND TAXES
The Fund qualified during the last fiscal year for the tax treatment applicable
to regulated investment companies under the Internal Revenue Code ("Code") and
intends to so qualify in the future. Such qualification requires distributing at
least 90% of its investment company taxable income to shareholders and meeting
asset diversification and other requirements of the Code. As long as the Fund so
qualifies, it does not pay federal income tax on its net investment income or on
any net realized capital gains provided such income and capital gains are
distributed to shareholders. If for any taxable year the Fund does not so
qualify, all of its taxable income, including any net realized capital gains,
will be taxed at regular corporate rates (without any deduction for
distributions to shareholders).
24
<PAGE> 42
The Fund is subject to a 4% excise tax to the extent it does not make certain
distributions to its shareholders. Such distributions must total (1) at least
98% of ordinary income (investment company taxable income subject to certain
adjustments) for any calendar year and (2) 98% of capital gains net income for
the 12 months ended October 31 of such year. The Fund intends to distribute
sufficient amounts to avoid liability for this excise tax.
If shares of the Fund are sold or exchanged within 90 days of acquisition, and
shares of the same or a related mutual fund are acquired, to the extent the
sales charge is reduced or waived on the subsequent acquisition, the sales
charge may not be used to determine the basis in the disposed shares for
purposes of determining gain or loss. To the extent the sales charge is not
allowed in determining gain or loss on the initial shares, it is capitalized in
the basis of the subsequent shares.
Under federal tax law, any loss a shareholder realizes on redemption of Fund
shares held for less than six months is treated as a long-term capital loss to
the extent of any long-term capital gain distribution which was paid on such
Fund shares.
Prior to purchasing Fund shares, the impact of dividends or capital gains
distributions should be carefully considered. Any such payments made to a
shareholder shortly after purchasing Fund shares reduce the net asset value of
such Fund shares to that extent and unnecessarily increase sales charges. All or
a portion of such dividends or distributions, although in effect a return of
capital, is subject to taxes, possibly at ordinary income tax rates.
Dividends and distributions declared payable to shareholders of record after
September 30 of any year and paid before February 1 of the following year are
considered taxable income to shareholders on the record date even though paid in
the next year. To the extent determined each year, a portion of the dividends
paid to shareholders from the Fund's net investment income qualifies for the 70%
dividends received deduction for corporations.
Some shareholders may be subject to 31% withholding on reportable dividends,
capital gains distributions and redemption payments ("backup withholding").
Generally, shareholders subject to backup withholding are those for whom a
taxpayer identification number is not on file with the Fund or who, to the
Fund's knowledge, furnished an incorrect number. When establishing an account,
an investor must certify under penalty of perjury that such number is correct
and that he or she is not subject to backup withholding.
Under existing provisions of the Code, dividends paid to shareholders who are
nonresident aliens may be subject to a 30% federal withholding tax applicable to
foreign individuals and entities unless a reduced rate of withholding or a
withholding exemption is provided under applicable treaty law. Nonresident
shareholders are urged to consult their own tax advisers concerning the
applicability of the federal withholding tax.
The foregoing is a general and abbreviated summary of the applicable provisions
of the Code and Treasury Regulations presently in effect. For the complete
provisions, reference should be made to the pertinent Code sections and Treasury
Regulations. The Code and these Treasury Regulations are subject to change by
legislative or administrative action either prospectively or retroactively.
25
<PAGE> 43
Each investor should consult his or her own tax adviser as to federal tax laws
and the effect of state and local tax laws which may differ from federal tax
laws.
FINANCIAL STATEMENTS
DETERMINATION OF NET ASSET VALUE, REDEMPTION PRICE AND OFFERING PRICE PER SHARE
- - March 31, 1996
<TABLE>
<S> <C>
Net asset value and redemption price per share
(net assets divided by shares outstanding)....................... $27.55
Offering price per share
(100/93.5 of per share net asset value).......................... $29.47
</TABLE>
The offering price is reduced on purchases of $10,000 or more; see "Purchase and
Redemption of Shares - Sales Charge" herein and "Purchase of Shares - Table of
Sales Charges" in the Prospectus.
26
<PAGE> 44
PORTFOLIO OF INVESTMENTS
March 31, 1996
<TABLE>
<CAPTION>
COMMON STOCKS Shares Cost Value
- ----------------------------------------------- ------- ---------- -----------
<S> <C> <C> <C>
TECHNOLOGY -- 23.4%
Arrow Electronics, Inc.*....................... 350,000 $ 9,616,980 $16,450,000
Exabyte Corporation*........................... 275,000 3,776,683 4,485,937
Fluke Corporation.............................. 159,900 5,134,594 6,096,187
Keithley Instruments, Inc...................... 200,000 1,227,092 2,800,000
Komag, Incorporated*........................... 327,800 2,833,000 7,949,150
Marshall Industries*........................... 400,000 6,492,648 12,200,000
Photronics, Inc.*.............................. 75,000 441,250 1,598,438
Quantum Corporation*........................... 385,000 6,572,237 6,930,000
Seagate Technology, Inc.*...................... 400,000 4,266,075 21,900,000
Storage Technology Corporation*................ 500,000 10,773,165 13,062,500
----------- -----------
$51,133,724 $93,472,212
----------- -----------
FINANCIAL -- 21.7%
Comdisco, Inc.................................. 575,000 $ 6,578,555 $12,721,875
Countrywide Credit Industries, Inc............. 550,000 9,459,401 12,168,750
Foremost Corporation of America................ 50,000 1,672,500 2,750,000
Green Tree Financial Corporation............... 1,100,000 891,133 37,812,500
Quick & Reilly Group, Inc., The................ 542,850 2,803,456 16,014,075
UnionFed Financial Corporation (Warrants)*..... 314,286 122,210 --
Westcorp....................................... 280,001 1,790,553 5,180,015
----------- -----------
$23,317,808 $86,647,215
----------- -----------
RETAILING -- 12.0%
Claire's Stores, Inc........................... 559,950 $ 5,050,336 $10,149,094
Good Guys, Inc., The*.......................... 525,000 4,764,000 4,593,750
Mac Frugal's Bargains Close-outs Inc.*......... 900,000 11,874,821 12,600,000
Ross Stores, Inc............................... 820,000 9,868,938 20,602,500
----------- -----------
$31,558,095 $47,945,344
----------- -----------
CONSUMER DURABLES -- 8.1%
Coachmen Industries, Inc.+..................... 373,000 $ 3,817,368 $ 9,791,250
Fleetwood Enterprises, Inc..................... 290,000 4,035,995 7,177,500
Flexsteel Industries, Inc...................... 160,000 2,008,125 1,600,000
Recoton Corporation*........................... 460,000 7,103,270 8,797,500
Thor Industries, Inc........................... 275,000 3,140,956 5,156,250
----------- -----------
$20,105,714 $32,522,500
----------- -----------
CONSUMER NON-DURABLES -- 6.2%
NIKE, Inc. (Class "B")......................... 90,000 $ 157,187 $ 7,312,500
Rawlings Sporting Goods Company, Inc.*......... 225,000 2,573,461 1,856,250
Reebok International Ltd....................... 565,000 17,871,206 15,608,125
----------- -----------
$20,601,854 $24,776,875
----------- -----------
</TABLE>
27
<PAGE> 45
PORTFOLIO OF INVESTMENTS
Continued
<TABLE>
<CAPTION>
Shares or
Principal
COMMON STOCKS CONTINUED Amount Cost Value
- -------------------------------------------------- ------------ ------------ ------------
<S> <C> <C> <C>
BASIC MATERIALS -- 2.9%
International Aluminum Corporation................ 200,000 $ 4,117,806 $ 5,350,000
Rouge Steel Company (Class "A")................... 275,000 5,996,275 6,084,375
------------ ------------
$ 10,114,081 $ 11,434,375
------------ ------------
INDUSTRIAL SERVICES -- 2.1%
Angelica Corporation.............................. 400,000 $ 9,393,476 $ 8,500,000
------------ ------------
DEFENSE -- 1.3%
Diagnostic/Retrieval Systems, Inc. (Class "A")*+.. 310,000 $ 1,646,478 $ 2,480,000
Diagnostic/Retrieval Systems, Inc. (Class "B")*+.. 200,000 861,240 1,587,500
United Industrial Corporation..................... 197,500 2,671,212 1,036,875
------------ ------------
$ 5,178,930 $ 5,104,375
------------ ------------
PRINTING & PUBLISHING -- 0.9%
Devon Group, Inc.*................................ 125,000 $ 2,884,000 $ 3,562,500
------------ ------------
TOTAL COMMON STOCKS -- 78.6%...................... $174,287,682 $313,965,396
------------ ------------
PREFERRED STOCK -- 0.4%
Craig Corporation (Class "A")*.................... 160,000 $ 1,906,272 $ 1,760,000
------------ ------------
NON-CONVERTIBLE BONDS -- 5.2%
Federal Home Loan Mortgage Corporation
(CMO) -- 7% 2020................................. $5,000,000 $ 4,981,250 $ 4,920,312
Federal Home Loan Mortgage Corporation
(PAC IO-CMO) -- 7% 2020.......................... 3,755,714 979,459 1,046,905
Federal National Mortgage Association
(PAC-REMIC) -- 8-1/2% 2025....................... 7,000,000 7,021,875 7,122,500
Federal National Mortgage Association
(PAC IO-REMIC) -- 6% 2013........................ 6,871,104 483,492 487,419
Government National Mortgage Association
(REMIC) -- 7.99125% 2010......................... 7,122,033 7,122,032 7,175,448
------------ ------------
$ 20,588,108 $ 20,752,584
------------ ------------
</TABLE>
28
<PAGE> 46
PORTFOLIO OF INVESTMENTS
Continued
<TABLE>
<CAPTION>
Principal
Amount Cost Value
------ ---- -----
<S> <C> <C> <C>
SHORT-TERM INVESTMENT -- 1.3%
U.S. Treasury Notes -- 4-1/4% 5/15/96............................... $ 5,000,000 $ 4,901,719 $ 4,992,188
------------ -------------
TOTAL INVESTMENT SECURITIES -- 85.5%................................. $201,683,781 $ 341,470,168
============ -------------
OTHER SHORT-TERM INVESTMENTS -- 14.2%
Amoco Company -- 5.15% 4/2/96........................................ $15,000,000 $ 14,997,854
Shell Oil Company -- 5.33% 4/2/96.................................... 6,300,000 6,299,067
Hertz Corporation -- 5.35% 4/3/96.................................... 2,300,000 2,299,316
Ford Motor Credit Company -- 5.42% 4/4/96............................ 19,000,000 18,991,418
Hertz Corporation -- 5.43% 4/4/96.................................... 6,400,000 6,397,104
American General Corporation -- 5.39% 4/8/96......................... 6,000,000 5,993,712
State Street Bank Repurchase Agreement -- 4-3/4% 4/1/96
(Collateralized by U.S. Treasury Notes -- 7-3/4% 1999,
market value $1,589,676)........................................... 1,558,000 1,558,617
-------------
$ 56,537,088
-------------
TOTAL INVESTMENTS -- 99.7%........................................... $ 398,007,256
Other assets less liabilities -- 0.3%................................ 1,275,011
-------------
TOTAL NET ASSETS -- 100.0%........................................... $ 399,282,267
=============
</TABLE>
*Non-income producing securities
+Affiliate as defined in the Investment Company Act of 1940 by reason of
ownership of 5% or more of its outstanding voting securities.
See notes to financial statements.
29
<PAGE> 47
STATEMENT OF ASSETS AND LIABILITIES
March 31, 1996
<TABLE>
<CAPTION>
<S> <C> <C>
ASSETS
Investments at value:
Investment securities -- at market value
(identified cost $201,683,781)........................................... $341,470,168
Short-term investments -- at cost plus interest earned
(maturities 60 days or less)............................................. 56,537,088 $398,007,256
------------
Cash......................................................................... 99
Receivable for:
Dividends and accrued interest............................................. $ 770,082
Capital Stock sold......................................................... 611,110
Investment securities sold................................................. 427,186 1,808,378
------------ ------------
$399,815,733
LIABILITIES
Payable for:
Advisory fees and financial services....................................... $ 251,981
Capital Stock repurchased.................................................. 184,966
Accrued expenses and other liabilities..................................... 96,519 533,466
------------ ------------
NET ASSETS -- equivalent to $27.55 per share on 14,494,465
shares of Capital Stock outstanding.......................................... $399,282,267
============
SUMMARY OF SHAREHOLDERS' EQUITY
Capital Stock -- par value $0.01 per share; authorized
100,000,000 shares; outstanding 14,494,465 shares.......................... $ 144,945
Additional Paid-in Capital................................................... 249,257,922
Undistributed net realized gain on investments............................... 8,588,993
Undistributed net investment income.......................................... 1,504,020
Unrealized appreciation of investments....................................... 139,786,387
------------
Net assets at March 31, 1996................................................. $399,282,267
============
</TABLE>
See notes to financial statements.
30
<PAGE> 48
STATEMENT OF OPERATIONS
For the Year Ended March 31, 1996
<TABLE>
<CAPTION>
<S> <C> <C>
INVESTMENT INCOME
Interest.................................................................... $ 4,955,208
Dividends................................................................... 2,417,573
-----------
$ 7,372,781
EXPENSES
Advisory fees............................................................... $ 2,244,261
Financial services.......................................................... 337,579
Transfer agent fees and expenses............................................ 186,391
Custodian fees and expenses................................................. 45,115
Registration fees........................................................... 39,088
Audit fees.................................................................. 27,850
Postage..................................................................... 24,366
Directors' fees and expenses................................................ 19,980
Legal fees.................................................................. 16,838
Insurance................................................................... 13,920
Reports to shareholders..................................................... 12,630
Taxes, other than federal income tax........................................ 800
Other expenses.............................................................. 10,585 2,979,403
---------- -----------
Net investment income............................................... $ 4,393,378
-----------
NET REALIZED AND UNREALIZED GAIN ON INVESTMENTS
Net realized gain on investments:
Proceeds from sales of investment securities (excluding
short-term investments with maturities of 60 days or less)................ $ 68,223,067
Cost of investment securities sold.......................................... 33,524,187
------------
Net realized gain on investments.......................................... $34,698,880
Unrealized appreciation of investments:
Unrealized appreciation at beginning of year................................ $ 80,115,701
Unrealized appreciation at end of year...................................... 139,786,387
------------
Increase in unrealized appreciation of investments....................... 59,670,686
-----------
Net realized and unrealized gain on investments..................... $94,369,566
-----------
NET INCREASE IN NET ASSETS RESULTING
FROM OPERATIONS............................................................... $98,762,944
===========
</TABLE>
See notes to financial statements.
31
<PAGE> 49
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
For the Year Ended March 31,
--------------------------------------------------------------
1996 1995
--------------------------- -------------------------------
<S> <C> <C> <C> <C>
INCREASE IN NET ASSETS
Operations:
Net investment income............................ $ 4,393,378 $ 897,432
Net realized gain on investments................. 34,698,880 8,147,392
Increase in unrealized appreciation
of investments................................. 59,670,686 26,393,925
------------ --------------
Increase in net assets resulting
from operations.................................. $ 98,762,944 $ 35,438,749
Distributions to shareholders from:
Net investment income............................ $ (3,256,784) $ (732,029)
Net realized capital gains....................... (32,254,690) (35,511,474) (4,658,052) (5,390,081)
------------ --------------
Capital Stock transactions:
Proceeds from Capital Stock sold................. $ 123,331,788 $ 55,311,219
Proceeds from shares issued to
shareholders upon reinvestment
of dividends and distributions................. 29,555,959 4,873,246
Cost of Capital Stock repurchased................ (53,512,942) 99,374,805 (19,260,877) 40,923,588
------------ -------------- -------------- ------------
Total increase in net assets....................... $162,626,275 $ 70,972,256
NET ASSETS
Beginning of year, including
undistributed net investment income
of $367,426 and $202,023......................... 236,655,992 165,683,736
------------ ------------
End of year, including undistributed
net investment income
of $1,504,020 and $367,426....................... $399,282,267 $236,655,992
============ ============
CHANGE IN CAPITAL STOCK
OUTSTANDING
Shares of Capital Stock sold....................... 4,796,761 2,690,430
Shares issued to shareholders upon
reinvestment of dividends and
distributions.................................... 1,162,515 252,685
Shares of Capital Stock repurchased................ (2,027,718) (963,643)
------------ -----------
Increase in Capital Stock outstanding.............. 3,931,558 1,979,472
============ ===========
</TABLE>
See notes to financial statements.
32
<PAGE> 50
NOTES TO FINANCIAL STATEMENTS
March 31, 1996
NOTE 1 -- SIGNIFICANT ACCOUNTING POLICIES
The Fund is registered under the Investment Company Act of 1940, as a
diversified, open-end investment company. The Fund's primary investment
objective is long-term capital growth. Current income is a factor, but a
secondary consideration. The following is a summary of significant accounting
policies consistently followed by the Fund in the preparation of its financial
statements.
A. Security Valuation
Securities 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 last
bid price. Unlisted securities are valued at the most recent bid price.
Short-term investments with maturities of 60 days or less are valued at
cost plus interest earned, which approximates market value.
B. Federal Income Tax
No provision for federal income tax is required because the Fund 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 to its shareholders, in accordance with the minimum distribution
requirements of the Code, all of its taxable net investment income and
taxable net realized gains on investments.
C. Securities Transactions and Related Investment Income
Securities transactions are accounted for on the date the securities are
purchased or sold. Dividend income and distributions to shareholders are
recorded on the ex-dividend date. Interest income and expenses are recorded
on an accrual basis.
NOTE 2 -- PURCHASES OF INVESTMENT SECURITIES
Cost of purchases of investment securities (excluding short-term
investments with maturities of 60 days or less) aggregated $103,688,515 for the
year ended March 31, 1996. Realized gains or losses are based on the
specific-certificate identification method. Cost of securities held at March 31,
1996 was the same for federal income tax and financial reporting purposes.
NOTE 3 -- ADVISORY FEES AND OTHER AFFILIATED TRANSACTIONS
Pursuant to an Investment Advisory Agreement, advisory fees were paid by
the Fund to First Pacific Advisors, Inc. (the "Adviser"). Under the terms of
this Agreement, the Fund pays the Adviser a monthly fee calculated at the annual
rate of 0.75% of the first $50 million of the Fund's average daily net assets
and 0.65% of the average daily net assets in excess of $50 million. In addition,
the Fund pays the Adviser an amount equal to 0.1% of the average daily net
assets for each fiscal year in reimbursement for the provision of financial
services to the Fund. The Agreement provides that the Adviser will reimburse the
Fund for any annual expenses (exclusive of interest, taxes, the cost of any
supplemental statistical and research information, and extraordinary expenses
such as litigation) in excess of 1-1/2% of the first $30 million and 1% of the
remaining average net assets of the Fund for the year.
For the year ended March 31, 1996, the Fund paid aggregate fees of $19,500
to all Directors who are not affiliated persons of the Adviser. Legal fees were
for services rendered by O'Melveny & Myers, counsel for the Fund. A Director of
the Fund is of counsel to, and a retired partner of, that firm.
33
<PAGE> 51
NOTES TO FINANCIAL STATEMENTS
Continued
NOTE 4 -- DISTRIBUTOR
For the year ended March 31, 1996, FPA Fund Distributors, Inc.
("Distributor"), a wholly owned subsidiary of the Adviser, received $127,932 in
net Fund share sales commissions after reallowance to other dealers. The
Distributor pays its own overhead and general administrative expenses, the cost
of supplemental sales literature, promotion and advertising.
NOTE 5 -- SALES OF FUND SHARES
Shares of the Fund are presently offered for sale only to existing
shareholders and to directors, officers, and employees of the Fund, the Adviser,
and affiliated companies. The discontinuation of sales to new investors reflects
Management's belief that unrestrained growth in the Fund's net assets might
impair investment flexibility. The Fund may resume at any time the sale of its
shares to new investors if, in the Board of Directors' opinion, doing so would
be in the best interests of the Fund and its shareholders.
34
<PAGE> 52
REPORT TO INDEPENDENT AUDITORS
TO THE BOARD OF DIRECTORS AND
SHAREHOLDERS OF FPA CAPITAL FUND, INC.
We have audited the accompanying statement of assets and liabilities of FPA
Capital Fund, Inc., including the portfolio of investments, as of March 31,
1996, and the related statement of operations for the year then ended, the
statement of changes in net assets for each of the two years in the period then
ended, and the financial highlights on page 4 of the Prospectus for each of the
ten years in the period then ended. These financial statements and financial
highlights are the responsibility of the Fund'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. Our procedures included confirmation of securities owned as of March
31, 1996, 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 FPA
Capital Fund, Inc. at March 31, 1996, the results of its operations for the year
then ended, the changes in its net assets for each of the two years in the
period then ended, and the financial highlights on page 4 of the Prospectus, for
each of the ten years in the period then ended in conformity with generally
accepted accounting principles.
/s/ ERNST & YOUNG LLP
---------------------------------
ERNST & YOUNG LLP
Los Angeles, California
April 19, 1996
35
