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General Electric (NYSE:GE) was for many years an iconic company, considered good as gold in the glory days when Jack Welch was at the helm. The company's strength was seriously questioned during the meltdown in early 2009, and the last time I looked into buying it, shares were trading at 6.66, on 3/6/09. I didn't buy any. It has since recovered to close Friday at 16.35. At the current price, GE represents a chance to follow the smart money into financials, with substantial gains if the company can regain its former performance and stature.

Buffett and GE - the smart money in this case would be Warren Buffett. Here is an excerpt from the 8-K, from October 2008:

On October1, 2008, General Electric Company (“GE”) agreed to issue and sell, and Berkshire Hathaway Inc. agreed to purchase, (1) shares of GE’s 10% cumulative perpetual preferred stock, par value $1.00 per share, having an aggregate liquidation value of $3.0 billion (the “Preferred Stock”), and (2) a warrant (the “Warrant”) to purchase 134,831,460 shares of GE’s common stock, par value $0.06 per share (the “Common Stock”), for an aggregate purchase price of approximately $3.0 billion in cash. The Preferred Stock will be redeemable at GE’s option after three years, in whole or in part, at a price of 110% of liquidation value plus accrued and unpaid dividends. The Warrant will be exercisable at the holder’s option at any time and from time to time, in whole or in part, for five years at an exercise price of $22.25 per share of Common Stock. The transaction is expected to close on or about October 16, 2008.

Buffett did a similar deal with Goldman Sachs (NYSE:GS), for 5 billion, with the warrants at 115. He made a fine profit on GS; but as of this moment, Warren's warrants for GE are not in the money.

Doing what has been working - the last time I tried this approach, I followed Warburg Pincus into Webster Bank (NYSE:WBS), with very pleasing results. In the interest of doing more of what has been working, GE seems like a good case. Buffett made a large profit on GS, but has yet to hit pay-dirt on GE. The warrants at 22.25 can serve as a low end target, under the premise that Buffett is frequently successful in his dealings and did well on GS with a very similar setup.

Smart Money - Buffett is known as the Oracle of Omaha. His basic approach is to hold enough cash that he can write checks when others can't or won't. He favors large, powerful companies with wide moats, and frequently manages to buy them at very attractive prices. The warrants are a nice touch: the 10% interest he received seems extremely generous in retrospect; but the warrants, which looked like an afterthought at the time, have the potential to create even better returns. He didn't actually pay anything for them.

Valuation – Working with 5 year average EPS, iconic companies frequently trade at a P/E of 20 to 25 on that metric. Using actual earnings for 2007-2009, and adding industry consensus estimates for 2010 and 2011, I project 5 year average EPS at 1.49 as of year end 2011. Applying a multiple of 20 gives a target of 30. That looks about right: Warren's warrants at 22.25 would make him a handsome profit, similar to what he has on GS.

Is Immelt as good as Welch?- Jack Welch was widely admired during his final years at the helm of GE. A problem that sometimes arises when a superstar CEO is doing his last laps before retirement is that performance must rise to a grand finale, so he can go out on a high note. There is a tendency to push things to the limit and put off recognizing any problems that can be deferred.

I don't have any information that this was the case at GE. Nevertheless, I would not judge the current CEO, Jeff Immelt, by comparing him to Welch. The situation that arose for all financials during the meltdown was a very tough test – any weaknesses that existed were exposed by the repetitious stress of successive credit tightening, a veritable Inquisition for Financial Sins.

Analyst Coverage – GE is followed by a great many analysts, most of whom give it high grades. Buffett is no slouch when it comes to picking winners, and his opinion could be factored in. Buffett purportedly does not do due diligence in the usual sense, but his judgment in cases of this kind may be better than an army of accountants (or analysts).

One point to be aware of here is that long term debt as a percentage of equity is very high at 80%. S&P rates the company AA+, down from triple A before the crisis. The current ratio stood at 2.7 as of the end of 2009, sufficient to make a liquidity crunch unlikely.

The company needs a strong recovery to regain its lost luster. Beta is 1.6 and the stock can be expected to under-perform a fearful market. Actual risk, giving credence to S&P's AA+, is much less than beta implies.

The dividend – GE cut its dividend from .31 quarterly to .10, to conserve cash. Immelt recently talked optimistically about raising the dividend, which would be a catalyst if and when it occurs.

Options Strategy - this is another situation where the use LEAPS as a substitute for share ownership makes sense to me. The Jan 2012 10 calls are attractively priced, and the sale of Dec 2010 19 calls would cover the entire time premium, creating a durable, leveraged and low cost position. If at the December expiration the shares are above 19, the investor has a fine 65% annualized return. Otherwise, he has another year to wait for appreciation and possibly collect premium by selling more covered calls.

The 10 strike on the long call is well above the low of 5.73 hit during the crisis, and given that the cost of maintaining the position in options is trivial, the limited downside exposure is a welcome addition, low cost protection. The risk that GE would ever get down to that area is remote, but there is no reason to forgo the protection.

Disclosure: GE - The author intends to execute the strategy described during the coming week. WBS and BRK.A, no positions.

Source: Following the Smart Money Into General Electric