SOURCE CAPITAL /DE/ — Regulatory Filings 2000

Aug 22, 2000

[LOGO] SOURCE CAPITAL, INC. SEMI-ANNUAL REPORT for the six months ended June 30, 2000 SOURCE CAPITAL, INC. [LOGO] DIRECTORS Willard H. Altman, Jr. Wesley E. Bellwood Eric S. Ende David Rees Paul G. Schloemer Lawrence J. Sheehan OFFICERS Eric S. Ende, PRESIDENT AND CHIEF INVESTMENT OFFICER Steven R. Geist, SENIOR VICE PRESIDENT AND FIXED-INCOME MANAGER J. Richard Atwood, TREASURER Sherry Sasaki, SECRETARY Christopher H. Thomas, ASSISTANT TREASURER INVESTMENT ADVISER First Pacific Advisors, Inc. 11400 West Olympic Blvd., Suite 1200 Los Angeles, California 90064 CUSTODIAN State Street Bank and Trust Company Boston, Massachusetts COUNSEL O'Melveny & Myers LLP Los Angeles, California TRANSFER AND SHAREHOLDER SERVICE AGENT ChaseMellon Shareholder Services, L.L.C. 85 Challenger Road Overpeck Centre Ridgefield Park, NJ 07660 (800) 279-1241 or (201) 329-8660 REGISTRAR ChaseMellon Shareholder Services, L.L.C. Ridgefield Park, New Jersey STOCK EXCHANGE LISTING New York Stock Exchange: Symbols: SOR Common Stock SOR+ Preferred Stock SUMMARY FINANCIAL INFORMATION

• -------------------------------------------------------------------------------- DESCRIPTION OF THE COMPANY SOURCE CAPITAL, INC. is a major diversified, publicly traded investment company with total net assets of approximately $417,000,000. Its investment portfolio includes a wide range of securities with primary emphasis on common stocks and convertible debentures. Source Capital has Common and Preferred shares outstanding, both of which are traded on The New York Stock Exchange. The 1,969,212 outstanding Preferred shares each have a prior claim of $27.50 on assets and $2.40 per year on income. The balance of the Company's assets and income are available to the 7,760,207 shares of Common Stock. Source Capital's investment objective is to seek maximum total return for Common shareholders from both capital appreciation and investment income to the extent consistent with protection of invested capital and provision of sufficient income to meet the dividend requirements of Preferred shareholders. Source Capital is not a mutual fund. Thus, it does not repurchase its own shares on demand and does not need to structure its portfolio securities to provide for possible redemptions. As a publicly traded investment company, Source Capital's Common and Preferred shares are bought and sold on The New York Stock Exchange, and the Company is not involved in the transaction. Source Capital's investment approach emphasizes primarily equity and equity-related investments in seeking to achieve its growth objective for its Common shareholders. The desirability of equity versus fixed-income investments has been increasingly debated in recent years. Source Capital's position is that without assuming undue risk and recognizing the fixed claim of its Preferred Stock, properly selected stocks offer the better long-term opportunity for overall investment return as well as long-term protection from the large but uncertain threat of inflation. Source Capital's equity investments have been directed toward companies with highly liquid, relatively unleveraged balance sheets and a demonstrated long-term ability to earn above average returns on invested capital. Source Capital's equity investment portfolio is based on fundamental judgments of long-term returns attainable from income and appreciation in the securities of such companies and is not derived from overall economic forecasts or stock market predictions. Source Capital has a Common Stock Distribution Policy which provides for cash distributions of approximately 10% of the ongoing net asset value of its Common shares. Only a portion of such distributions is paid from net investment income. The remainder is paid from any net realized capital gains and/or paid-in capital, as determined by each year's results. To the extent the Company realizes net long-term capital gains for any year in excess of the amounts distributed under the Company's distribution policy, such excess may be distributed to shareholders or retained by the Company. Distributions to Common shareholders are paid quarterly in a fixed amount which is periodically adjusted after sustained changes in net asset value appear to the Board of Directors reasonably likely to support the new distribution rate on a continuing basis. This policy is designed to allow Common shareholders to benefit not only from income, but a portion of the capital appreciation which has resulted to date. All distributions are taxable to shareholders as dividend income or capital gain distributions since the Company has accumulated earnings and profits from prior years. Since the policy was adopted in June 1976, at an initial annual rate of $1.40 per share, continued increases in net asset value, despite payments from capital, have permitted 20 subsequent increases to the current rate of $4.60. Maintenance of the current $4.60 annualized rate is dependent upon achieving a total return on the Common Stock from both income and appreciation to sustain a net asset value of approximately $46.00. 1 LETTER TO SHAREHOLDERS TO OUR SHAREHOLDERS: Source Capital's total net assets decreased from $456,768,629 to $416,738,249 during the second quarter. Net asset value per Common share amounted to $46.72 at June 30, 2000 compared with $52.12 at March 31, 2000 and $50.70 at year-end 1999. These changes in net asset value were net of cash distributions of $1.10 and $1.15 paid in the first and second quarters, respectively. INVESTMENT RESULTS, 2000 FIRST HALF For the six months ended June 30, 2000 the net asset value per share of Source Capital's Common Stock decreased by 2.4%, including distributions paid during the period, while total net assets declined 2.7%. These returns compare with a 5.7% increase in the Russell 2500 Index. The foregoing changes were calculated on the basis of reinvesting all dividends and distributions. INVESTMENT RESULTS, 2000 SECOND QUARTER In the most recent quarter, Source Capital's net asset value per share of Common Stock decreased 8.3%, including the $1.15 distribution paid during the period, while total net assets declined 10.0%, both on a reinvestment basis. In comparison, the Russell 2500 Index decreased 4.0% during the quarter, also on a reinvestment basis. NET INVESTMENT INCOME Net investment income amounted to $1,534,863 and $2,966,717 for the second quarter and six months, respectively, as against $1,110,058 and $2,303,411 in the comparable periods of 1999. After providing for Preferred dividends, net investment income per Common share was $0.05 and $0.08 for the quarter and six-month periods, respectively, compared to each of the corresponding periods of 1999 when Preferred dividends exceeded net investment income by $0.01. DISTRIBUTIONS TO COMMON SHAREHOLDERS A regular quarterly distribution of $1.15 per share was paid on June 15, 2000 to shareholders of record on May 26, 2000. This payment marks the 24th anniversary of Source Capital's 10% Distribution Policy which calls for total annual payments approximating 10% of the Common Stock's ongoing net asset value. Since the adoption of this policy, continuing growth in net asset value has led to 20 increases in the distribution rate totaling 229%--from the original $1.40 rate in June 1976, to the current $4.60 rate. The growth in the net asset value which has permitted this continuing expansion in cash distributions has been achieved despite distributions in excess of net investment income of $423,925,154 or $62.87 per Common share, and payments of federal income tax on undistributed realized capital gains amounting to $36,198,677 or $5.99 per Common share. Maintenance of the current $4.60 rate is dependent upon achieving long-term investment results which sustain a net asset value of approximately $46.00. PREFERRED DIVIDENDS The regular Preferred dividend of $0.60 per share was paid on June 15, 2000, to shareholders of record on May 26, 2000. The changes in the Company's total net assets since year-end 1999 have resulted in changes in the Preferred shares' asset coverage from 821% at December 31, 1999 to 843% at March 31, 2000, and 770% at June 30, 2000. The increase in net investment income led to a rise in Preferred dividend coverage to 130% for the second quarter and 126% for the six months, compared to 94% and 97% for the corresponding periods of 1999. MARKET PRICE OF SOURCE CAPITAL SHARES The market price of Source Capital Common Stock increased from $48 1/4 to $49 9/16 during the first half of 2000. As this $1.31 increase in market price was more than the $3.98 decline in the underlying net asset value, the market discount from net asset value of 4.8% at year-end 1999 reverted to a premium of 6.1% at June 30, 2000. The market price of Source Capital Preferred Stock decreased to $27 13/16 at June 30, 2000 from $28 at year-end 1999. COMMENTARY The stock market retreated in the second quarter, with all major indexes declining. Source participated in this negative performance, with a decline of 8.3%, compared to 4% for the Russell 2500. For most longer periods Source has done well, with the exception of the past 12 months, when the outperformance of tech stocks has distorted the results.

• Annualized This quarter, I thought it might be of interest to shareholders to discuss some companies which have been in Source Capital's portfolio for a number of years, but are still probably relatively unfamiliar. They each possess the attributes we seek--high returns on capital, good growth prospects, and strong balance sheets, combined with modest valuations. None of these companies are in glamorous businesses, but each is the leader in its industry, has a reliable revenue stream on which it earns high margins, and has demonstrated the ability to reinvest capital both in its existing business and in closely related acquisitions. BACOU USA is the leader in making personal protection equipment--products that protect industrial and construction workers from injuries. Starting out with the North American rights to the well-known Uvex brand of safety glasses, Bacou used its cash flow to acquire leading brands of other safety products, notably hearing protection, gloves, and respiratory systems. In each of its major product categories, Bacou holds the first or second market share position. Bacou's products are sold principally through industrial safety equipment distributors or distributors of general industrial supplies like W.W. Grainger. Having a broader product line gives manufacturers like Bacou more clout with these distributors, and strengthens its competitive advantage compared to others who sell only a few products. Attaining and increasing this competitive advantage is the main stimulus behind Bacou's successful acquisition program. Bacou USA is majority owned by a private French company, Bacou S.A. The French firm recently announced that, in order to insure an adequate supply of capital to continue the industry consolidation acquisition strategy, both in the U.S. and in Europe, Bacou will put itself up for sale. Both the majority French shares and the minority shares in Bacou USA would be sold on the same basis. If the sale process is successful, a fall announcement and year-end closing would be likely. A transaction price in the high $20s would be a realistic expectation. Prior to the sale announcement Bacou was trading at $20, compared with expected 2000 earnings of $1.80 per share. It is now about $24. 2 DENTSPLY INTERNATIONAL is the leading worldwide manufacturer of dental products. This is an industry which has had excellent growth rates, driven by improving technology, an aging population, and rising income levels in developing countries. Dentsply's leading market shares for most of its products and its strong cash flows have enabled it to fully participate in this industry growth. It has invested aggressively in research and development and has steadily introduced new and innovative products. The company is enhancing the effectiveness of these products by significantly expanding its sales force, which calls directly on dentists. Finally, Dentsply has been successful in expanding the scope of its business through its acquisition program, adding a number of new product areas to its portfolio, most notably endodontics. DONALDSON COMPANY is a manufacturer of filtration products for large engines. Its product mix includes both air and liquid filters, as well as exhaust and emission control products. Although investors have traditionally viewed Donaldson as strongly linked to the U.S. heavy truck cycle, this is in fact no longer the case. Half of Donaldson's mobile engine business comes from products sold into the aftermarket, where demand depends on miles driven, not new truck purchases. Much of the rest of its engine business is with producers of agricultural or construction equipment (Deere, Caterpillar, etc.) or foreign truck manufacturers. Although these are cyclical businesses, their cycles are generally out of phase with U.S. heavy trucks. In addition, Donaldson has a substantial business providing filters for stationary gas turbine engines, as well as for machinery in factories. Finally, Donaldson sells specialty filters to such rapidly growing markets as disk drives and semiconductor manufacturing. Donaldson's success at diversifying its customer base has produced a decade of double-digit earnings growth, along with high returns on capital, a record which we feel is not reflected in its current valuation of just 13x trailing 12-month earnings.

As can be seen in the table, these companies have demonstrated financial performance well above the average as represented by the Russell 2500, while selling at lower valuations. This relationship, which is true of the Source portfolio as a whole, is one of our key investment objectives, and a reason that we are optimistic about Source's future prospects. Respectfully submitted, /s/ ERIC S. ENDE Eric S. Ende President and Chief Investment Officer August 5, 2000 3 PORTFOLIO OF INVESTMENTS June 30, 2000

4 PORTFOLIO OF INVESTMENTS

5 PORTFOLIO OF INVESTMENTS

• Non-income producing securities + Restricted security purchased without registration under the Securities Act of 1933 pursuant to Rule 144A, which generally may be resold only to certain institutional investors prior to registration. ++ Affiliate as defined in the Investment Company Act of 1940 by reason of ownership of 5% or more of its outstanding voting securities. Following is a summary of transactions in securities of these affiliates during the six months ended June 30, 2000.

See notes to financial statements. 6 MAJOR PORTFOLIO CHANGES Quarter Ended June 30, 2000

(1) Indicates new commitment to portfolio (2) Indicates elimination from portfolio 7 STATEMENT OF ASSETS AND LIABILITIES

See notes to financial statements. 8 STATEMENT OF OPERATIONS For the six months ended June 30, 2000

See notes to financial statements. 9 STATEMENT OF CHANGES IN TOTAL NET ASSETS

See notes to financial statements. 10 FINANCIAL HIGHLIGHTS Selected data for a share of Common Stock outstanding throughout each period

(1) Based on market value per share, adjusted for reinvestment of distributions and taxes (2) Based on net asset value per share, adjusted for reinvestment of distributions and taxes (3) Annualized (4) Information shown as of the end of the period (5) The average of all month-end market values during each period See notes to financial statements. 11 NOTES TO FINANCIAL STATEMENTS June 30, 2000 NOTE A--SIGNIFICANT ACCOUNTING POLICIES The Company is registered under the Investment Company Act of 1940 as a diversified, closed-end management investment company. The investment objective of the Company is to seek maximum total return for Common shareholders from both capital appreciation and investment income to the extent consistent with protection of invested capital and provision of sufficient income to meet the dividend requirements of Preferred shareholders. The significant accounting policies followed by the Company in the preparation of its financial statements include the following: 1. SECURITIES VALUATION--Securities, including any outstanding written call options, listed or traded on a national securities exchange or on the NASDAQ National Market System are valued at the last sale price on the last business day of the period, or, if there was not a sale that day, at the mean between the most recent bid and asked prices. Securities which are unlisted and debt and convertible securities listed on a national securities exchange for which the over-the-counter market more accurately reflects the securities' value in the judgment of the Company's officers, are valued at the mean between the most recent bid and asked prices or other ascertainable market value. Short-term investments with maturities of 60 days or less are valued at cost plus interest earned, which approximates market value. Restricted securities and securities for which market quotations are not readily available are valued at fair value as determined in good faith by, or under the direction of, the Board of Directors. 2. FEDERAL INCOME TAX--No provision for federal taxes is considered necessary because the Company has elected to be taxed as a "regulated investment company" under the Internal Revenue Code, and intends to maintain this qualification and to distribute each year all of its taxable net investment income and taxable net realized gain on investments to its shareholders in accordance with the minimum distribution requirements of the Code. 3. USE OF ESTIMATES--The preparation of the financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ from those estimates. 4. OTHER--Securities transactions are accounted for on the date securities are purchased or sold. Dividend income is recorded on the ex-dividend date. Interest income and expenses are recorded on an accrual basis. Dividends payable by the Company on the Preferred Stock are recorded on an accrual basis and distributions payable on the Common Stock are recorded on the ex-dividend date. NOTE B--CAPITAL STOCK The Preferred Stock is entitled in liquidation to $27.50 per share plus accrued dividends and may be called for redemption, at the discretion of the Company, at $27.50 per share plus accrued dividends. Dividends may not be declared on the Common Stock if Preferred dividends are in arrears or if the Preferred Stock would not thereafter have an asset coverage of 200% or more. The Company issued 62,563 shares of Common Stock under its Reinvestment Plan for Common and Preferred shareholders during the six months ended June 30, 2000. NOTE C--ADVISORY FEES AND OTHER AFFILIATED TRANSACTIONS Pursuant to an investment advisory agreement, the Company pays First Pacific Advisors, Inc. ("Investment Adviser") monthly investment advisory fees calculated at an annual rate of .725% for the first $100 million of total net assets, .700% for the next $100 million of total net assets, and .675% for any total net assets in excess of $200 million. The Agreement obligates the Investment Adviser to reduce its fee to the extent necessary to reimburse the Company for any annual expenses (exclusive of interest, taxes, the cost of any supplementary statistical and research information, legal expenses related to portfolio securities, and extraordinary expenses such as litigation) in excess of 1 1/2% of the first $30 million and 1% of the remaining average total net assets of the Company for the year. For the six months ended June 30, 2000, the Company paid aggregate fees of $45,000 to all Directors who are not affiliated persons of the Investment Adviser. During the six months ended June 30, 2000, the Company incurred legal fees of $3,772 payable to O'Melveny & Myers LLP, counsel for the Company. A Director of the Company is of counsel to, and a retired partner of, that firm. The Officers of the Company are also officers of the Investment Adviser. NOTE D--PURCHASES AND SALES OF SECURITIES Cost of purchases of investment securities (excluding short-term corporate notes with maturities of 60 days or less) aggregated $64,142,128 for the six months ended June 30, 2000. Cost of investment securities owned at June 30, 2000 was the same for federal income tax and financial reporting purposes. Gains and losses are based on the specific certificate identification method. Gross unrealized appreciation and depreciation for all investments at June 30, 2000 for federal income tax purposes was $95,628,187 and $36,933,400, respectively. NOTE E--CHANGE IN CONTROL OF INVESTMENT ADVISER United Asset Management Corporation (UAM), the parent of the Investment Adviser, has entered into an agreement to be acquired by Old Mutual plc, a United Kingdom-based financial services group with substantial asset management, insurance and banking businesses. This transaction will create a change in control of the Investment Adviser and, as required by the Investment Company Act of 1940, a new investment advisory agreement must be approved by shareholders upon this event. In anticipation, the Board of Directors of the Company has approved a new investment advisory agreement which will be submitted to shareholders at the special meeting scheduled for October 23, 2000. The Board has also approved an interim investment advisory agreement to take effect should the acquisition of UAM occur prior to the shareholder meeting date. Both investment advisory agreements are substantially the same as the current investment advisory agreement approved by shareholders on May 1, 2000. 12 RESULTS OF ANNUAL MEETING Following is a list of matters voted upon and the results of those votes cast at the annual meeting of shareholders held May 1, 2000: 1. With respect to the election of five directors by the holders of Common Stock, $1.00 par value, and election of two directors by the holders of $2.40 Cumulative Preferred Stock, $3.00 par value:

1. With respect to continuation of the Investment Advisory Agreement, a total of 8,015,271 shares voted for, 45,860 shares voted against and 124,867 shares abstained. 3. With respect to the selection of Ernst & Young LLP as independent auditors for the Company for the fiscal year, a total of 8,097,601 shares voted for, 26,202 shares voted against and 62,195 shares abstained. No broker non-votes were received with respect to any of the matters voted upon above. 13