Big Problems, Big Profits

One day in the fall of 1990, Warren Buffett picked up his ringing telephone.

An old friend from Manhattan was calling to give him the word on the street: The "smart money" was saying the bank in which Buffett had just made a huge investment was going to fail...

Buffett said, "We'll see who's right," and hung up.

During that year, 1990, things were going from bad to worse in real estate markets across the country. Banks were loaded up on bad loans they'd made during the booming 1980s. Because of this, 1990 became the worst year for banking since the Great Depression. By 1993, more than 1,500 federally insured banks would fail.

Half of Wells Fargo's $15 billion in real estate loans were made in southern California, where the boom had been bigger, and the bust looking much worse, than elsewhere. Wells Fargo's share price fell from $84 to $41.

In his annual letter that year, Buffett wrote, "We welcomed the decline [in Wells Fargo's share price], because it allowed us to pick up many more shares at the new, panic prices... The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."

If you'd invested $10,000 in Wells Fargo at the panic lows of 1990, your investment would be worth roughly $230,000 today, 23 times your money!

What Buffett found with Wells Fargo was a one-time huge but solvable problem. That's what makes stocks cheap, and investor profits huge. He likes the company so much, he's bought more of it recently.

We've done the same thing with several stocks in my advisory Extreme Value. A recent example is KLA-Tencor (KLAC). 

I recommended KLA last August, when it was mired deep in the options-backdating scandal. When the original announcement came out that KLA had discovered options backdating, the stock fell from above $50 to below $40. We recommended it just below $42 a share.

We cared a lot less about the options than we did about two other important items:

First, KLA-Tencor is the largest company in the world that provides yield management systems to semiconductor manufacturers. Most of the big semiconductor makers are customers of KLA. Its technology – hardware and software – helps manufacturers crank out the least number of unusable chips.

KLA's position as the No. 1 yield management company gives it a competitive advantage, very rare in the commodity-oriented world of semiconductors. In fact, Morningstar lists KLA-Tencor among the stocks with the widest economic moats, right alongside stalwarts like Coca-Cola and American Express (both Buffett holdings).

Second, KLA-Tencor's financial position is stronger than most companies on earth, period. As of its most recent filing, KLA-Tencor has about $2.14 billion of cash and securities... and just $1 billion in total liabilities.

It wasn't difficult to conclude that the options backdating would have virtually no effect on the two things we felt were most important about KLA-Tencor. The short-term problems didn't change the long-term value.

KLA began to put its cash hoard to work soon after we recommended the stock. It currently has a tender offer out for all the outstanding shares of Therma-Wave, a maker of process control technology for semiconductors.

And, as expected, the company announced an accelerated share repurchase program in the amount of $750 million, or about 7% of the outstanding shares today. It also added a new 10 million-share repurchase program... in addition to an existing 10 million-share program. In other words, the company is giving all that cash to shareholders.

With a little less than 200 million outstanding shares, the new repurchase programs are like a 12% tax-deferred dividend to shareholders. And with more than $2 billion in cash, KLA-Tencor could easily afford to buy back another 10% of its outstanding shares in addition to the announced repurchase programs. 

Buy a great stock when the short-term problems in the news push the price down, and you might wind up where we are with KLA today: Sitting on a 30% gain in less than eight months, with the promise of years of high double-digit compounding returns, as happened with Wells Fargo.