This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
One of the best stock pickers in the business, Am Tech/JSA Research, initiated coverage of Internet diamond dealer Blue Nile (NASDAQ:NILE) with a sell rating on Friday. Media reports of the downgrade don't do a very good job of explaining why Am Tech/JSA dissed the stock, which earlier in the week reported blockbuster results on both the sales and earnings fronts. But I think I can guess: With a trailing P/E of 66 and earnings projected to grow at just 20% per year over the next five years, this jewel of a stock is starting to look awfully high-end.

Did I say "jewel"? Perhaps "gem" would be more appropriate. After all, Blue Nile is an official recommendation of Motley Fool Hidden Gems -- and of Motley Fool Rule Breakers, too, where it has returned 72% and 79% profits, respectively, to investors who bought shares when the newsletters first recommended it.

With a valuation like that, and a price that ended the week 15% higher than it started it, perhaps Am Tech/JSA thinks the company overpriced. But analysts in general have a terrible record on this stock. Not once since it came public in May 2004 have they correctly predicted its earnings, and they've only overestimated this number once. In fact, they've underestimated it -- and, by extension, underestimated Blue Nile itself -- 11 times. Could that be what's happening now? Or can Am Tech/JSA buck the trend of too-pessimistic analysts and finally predict Blue Nile's downfall? For clues to this analyst's prescience, we turn once more to Motley Fool CAPS to take the measure of Am Tech/JSA's genius.

Nor is genius too strong a word to describe the company. Nine months into our project to discover Wall Street's best (and worst) stock pickers, we've found a real winner in Am Tech/JSA, which sports a CAPS rating of 98.55 and a record of making correct calls more than 62% of the time. Reviewing a few of its better picks, we find:

Of course, everyone makes mistakes. A few of Am Tech/JSA's notable blunders include:

With an enviable record of success behind it, and an apparently obvious overvalued stock in front of it, it's hard to argue that Am Tech/JSA is wrong to advise selling Blue Nile. Indeed, just glancing at the firm's P/E gives me the willies. Yet when I dig deeper into the numbers, I do see reason to suspect that Am Tech/JSA is making a wrong call here.

And not just because both Hidden Gems and Rule Breakers disagree with the analyst, either. Sure, both of our newsletters have proved themselves to be astute stock pickers and have beaten the S&P 500 over their history -- but so has Am Tech/JSA. No, what really has me thinking that Am Tech/JSA jumped the gun here are the numbers behind the P/E and, specifically, the fact that the firm generates much more cash profits (free cash flow) than it reports as net income under GAAP.

From a free cash flow perspective, the firm earned $32.2 million in cash profits over the past 12 months -- more than twice its reported net income. That gives Blue Nile a price-to-free cash flow ratio of just 27 and an enterprise value-to-free cash flow ratio of only 25. Weighed against the 20% projected earnings growth, these are premium prices, but not overly so. When you factor in the company's history of leaving analyst estimates in the dust, I think it's possible to argue that the company is perhaps even slightly undervalued today.

Put it all together, and -- the sky-high P/E notwithstanding -- I'm going to disagree with Am Tech/JSA's advice to sell Blue Nile.

Want a third opinion on the stock? Click here to visit Blue Nile's CAPS page, and find out what the No. 1-scoring CAPS player on this stock thinks about its prospects.

Fool contributor Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 1581 out of nearly 29,000 raters. Shanda is a Motley Fool Rule Breakers choice. The Fool has a disclosure policy.