In late July, I posted an analysis of Amylin Pharmaceuticals (AMLN) that was not exactly a favorite of Michael’s. I figured that my response belonged in a post rather than in the comments because it was more of a “noise vs. news” debate, and Michael responded in turn with some clarification. (It’s not easy to debate online because (a) space is limited and (b) 90% or so of communication – the nonverbal – is non-existent so we must rely on that unreliable 10% – the words.)

The whole discussion revolved around two simple concepts. I believed that Amylin was like every other company out there – that it had an intrinsic value and that, although I couldn’t peg the value, it was almost certainly less than $6 billion (the then market capitalization). Michael took a different side – Amylin was worth considerably more than $6 billion, and that smaller investors (operating within their own risk tolerance) should look to buy companies they know (Michael is a pharmacist by profession) before those companies make their billions.

We both approached the company rationally; still, we can’t fight the law – price follows value. Know the value and you’ll know what price to pay. Not sure of the value? Decision time: Move on? Or, leave your fate in the hands of the traders?

How to make money in stocks.

I’ve said it before – there are a million and one ways to make and lose money in the stock markets. You can be a value investor, a technical trader, a speculator, or anywhere in between. You can put your money in index funds; you can invest in mutual fund managers that follow a technique or style you like, but which you do not have time to implement. You can play penny stocks or follow the Dogs of the Dow.

No matter how you invest, you should study and learn new ways, new methods, and new strategies so that you can constantly reinforce (or improve) your own skills. It’s the reason that Buffett knows so much about technical trading, even though he never uses it in stocks; it’s why the Oracle can speak about anything and everything, even though he focuses on doing just a few things really well.

Your Sphere of Competence should be bigger than your Sphere of Confidence.

We can all get a touch of guru-itis – that psychological carcinogen that burns money faster than we can make it. When things are working and we’re making money, we begin to get comfortable. Things seem so easy that we believe that we are always right and that everything we touch will make money. I got a touch of the fever back in late December and I lost money splashing around in a pool I should not have been in.

Chuckling as I placed the trade, wy confidence was through the roof; my competence was not.

I don’t know about you, but I welcome these little episodes because I learn from them – not just in the traditional “learn from your mistakes” but in the actual “I remember every bonehead move I’ve ever made that lost money or that cost me an opportunity to make money.” (It helps that my business partner, Mike, constantly busts my chops, too. Hey Joe, did you see Bankrate (RATE) today? $42.50.)

For example: I bought RATE around $11 late in 2004, and then sold it when Wall Street disliked an earnings call and pushed the price down. I second-guessed my decision, got scared, dumped out around $9.50, and never bought in again. Oops. (Actually, it was many thousand shares, so this was a very large, six figure oops.)

The point is simple: You have a sphere of competence in which you should be looking for opportunities. The hardest part about investing is watching companies you don’t own run up like crazy. I would love to have bought Mosaic (MOS) in 2006 at $14 and change, and watch my investment grow ten-fold in a year. But I don’t have a very good grasp on phosphate, potash, and animal feed.

The sphere inside the sphere.

I do, however, have a small sphere of competence in technology. I’m not crazy about the sector as a whole; still, I do see some opportunities from time to time. (I don’t avoid it just because Buffett avoids it.) Inside that sphere of competence is a much smaller sphere – my confidence. I’ve owned very few “tech” companies in the past, but my sphere-inside-my-sphere allowed me to buy Google around $100 and Apple between $38 and $85, and sell them both around $185.

Was I wrong to sell Google around $185? No. At that point, the price shot out of my sphere of confidence, and I never saw it enter again. I would have welcomed the other $550 a share of growth; I would not have been happy hoping for it had the stock price tanked.

Price follows value, regardless of what your spheres tell you.

Money can be made in the stock market when you approach a company from the buy before they’ve made their billions perspective. It has served a number of early investors in Apple and Google, and will continue to work in the future. There is a flip side to that coin – if you merely speculate on companies that you think will make billions (and these are a plenty in biotech, just like in tech and the dot com boom/bust), you will end up with a ton of losers as well.

Price follows value – and Amylin is down some 50% in seven months. What is the value of Amylin? I can’t say for certain, but I do know that it is the value of the cash that can be taken out of the business during its remaining life. Until now, Amylin was worth nothing more than its break-up value. Why? Let me explain.

Cash taken out versus cash put in

My uncle, a small business owner, said something very interesting to me yesterday:

When you have to start putting cash into your business, it’s time to get out of your business.

If your business is not self-sufficient, it’s worthless. I’m not talking about “in a single quarter” or “in a particular year or two”, but in general – over the long-term, through good and bad times, taken as a whole.

Amylin has been increasing revenues. It has also been selling stock and borrowing money. (Surprisingly, this means very little to many investors.) At some point, it may become self-sufficient and mature to become a business with a value greater than its break-up value. Still, so long as it is not self-sufficient, so long as it is borrowing money and diluting its per share break-up value, it is worthless from a business-owner’s perspective.

You can bend the rule, but you can’t break it

The stock market is a place to buy and sell businesses, even if many people make their living or lose their retirements speculating on what the Greater Fool will do. Over the long-term, the price of a stock follows the value of the business – it’s the rule that has governed the markets for as long as we’ve had markets, and you can’t break it. In the short-term, price follows the daily trend of what the buyers and sellers are doing. In the short-term, price does not necessarily follow value.

Lest you think I consider seven months to be the long-term, I don’t. Over the past five years, Amylin has bent the rule – trading from as low as $13.73 to as high as $53.25. Today, it’s at $24 and change, down almost 50% over the past seven months.

What should Amylin be trading at? With no earnings (and hence, no P/E ratio) to guide some investors, and with no ability to generate cash and no idea of how well it will do so in the future to guide business investors, Amylin’s price is entirely in the hands of the traders. If you can’t put a value on Amylin, there is no way to know whether or not you are overpaying or underpaying, and no way to judge your potential returns. You can not possibly have any expectations, just hope.

Whether Amylin will be up or down 50% over the next seven months, I don’t know. If it “keeps doing what it’s doing,” I’ll know that it will be priced well above its value (currently, its break-up value) and I’ll know that its price is not guided by any business principals or valuations, but by the traders.

No matter which way it goes, I won’t be surprised at the results. Neither should you.