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.

Let’s narrow it down a bit.

Hemel asked,

One of my challenges has been creating screens to filter stocks. What items would you consider for this? I can understand basic things like industry, size of company etc but what about other tech and non-tech indicators?

I also got an e-mail asking,

One question I had was how do you pick which stocks to do extra [due diligence] and run the value numbers. Do you do a scan or look into up or down sectors? Do you just pick a company out of the air and run the numbers?

The Non-Method To My Madness

I have a number of different ways depending on how I feel that day.

One day, I’ll look at my Morningstar list of all companies with positive free cash flow for the last ten years-about 450 companies. Sometimes I’ll head over to the MSN free stock screener and scan for companies with 15%+ growth in earnings for the past few years. I also like to look at the companies whose products I use: Research in Motion for my Blackberry, HP for my computer monitor, Dell for my computer, etc. or stores in which my wife or I shop (she can single-handedly increase a company’s owner earnings!)

I also check the NYSE and NASDAQ sites daily to see which companies have had the biggest daily drops. When a company plummets quickly, it’s usually because of bad Wall Street news. I like to check those stocks out because they may still be wonderful businesses that the stock market is overreacting to.

I don’t have a specific method to my madness. I try to find opportunity wherever I can.

Use The Tools They Give You

When running free stock screeners, you’ll have to play Wall Street’s game to generate an initial list of targets. By that I mean that you’ll have to use their criteria for searching: growing earnings, high returns on equity and invested capital, etc.

I generally start by setting all of the growth rates to 15% or greater. After I get through that list, I’ll run it again with 10% growth rates.

If using the Morningstar premium screener, scan for companies with positive free cash flow for at least 6 or 7 years-preferably ten years.

The Big Losers

When a stock drops 5%, 10%, 20% or more, it may be that Wall Street is overreacting to news that will otherwise not affect the future health of the company. A prime example (which I screwed up on) was Bankrate in 2004. I bought the company around $11 a share.

A few days later, near the end of October, Wall Street overreacted to a less-than-stellar earnings report and pushed the stock down 16% to as low as $9.20. Stupid me-I panicked with them, convincing myself that they knew something I didn’t. I sold for a one week 10% loss. I was thinking like a gambler, not a business owner.

Two years later, it was a $50 stock. (As an aside, that was the very last time I ever listened to Wall Street.)

Find Opportunities Everywhere

Unfortunately there is no secret list or magic screener that will identify the best businesses. To drive this home, we turn to investment stud Peter Lynch:

The person that turns over the most rocks wins the game.

Of course, don’t expect to run a screen, analyze a business, and run out and buy one today. Sometimes there are great companies on sale; sometimes you’ll sit on the sidelines, accumulating cash and waiting weeks, months, or even a year or two for an opportunity. As Buffett says,

You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.

Remember: Finding a business worth buying is much more difficult than the act of buying. Turn over rocks-you’ll see a lot of grubs, worms, and dirt. Still, the very next rock may be sitting on a box of gold.