Blue Nile: Strong, but Imperfect

Editor's Note: With this column, we are thrilled to welcome Hewitt Heiserman back to RealMoney. Hewitt's earnings-power strategy provides a unique look at a company's fundamental performance.

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The savvy investor demands a margin of safety before buying a company's stock.

For Benjamin Graham, the intellectual patriarch of the value school of investing, this meant buying a company selling for less than two-thirds of net working capital after deducting all debt and other claims.

Graham's cast-iron discipline worked: after getting wiped out during the Great Depression, he went on to make 21% a year for the next 20 years. Buying cheap assets, Graham learned from hard experience, protected you in case of miscalculation or bad luck.

How can a growth-oriented investor add a measure of protection into their research process? I advise using a three-step process to minimize risk and maximize returns:

1) Gauge earnings quality,

2) Identify a durable competitive advantage, and

3) Buy at a discount to intrinsic value.

To illustrate, let's examine Blue Nile (NILE - commentary - Cramer's Take), the online diamond retailer that sells (but does not inventory) 60,000 mined diamonds, as well as engagement-ring settings, necklaces, bracelets and watches. The Seattle-based company boasts authentic earnings power and some durable competitive advantages, but, as we shall see, the shares aren't a buy, yet.

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As originally published, this column contained errors. Please see Corrections and Clarifications.

At the time of publication, Heiserman was long Blue Nile, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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