6 Signs That It Might Be Time To Short A Company

Hedge fund manager Scott Fearon wants to talk about failure. Not that he's had too many personal encounters with failure in his 25 years as a money manager - his fund has averaged an 11.4 percent return in that time, and 2009 was the only year it ever lost money.

But Fearon celebrates the concept of failure - and its importance in free market economies - in his recently-released book, Dead Companies Walking.

He's spent decades analyzing more than 1,400 companies across the country and meeting in person with the people who run them. And he draws on those experiences to illustrate, through anecdotes and cautionary tales, some of the best and worst traits to look for in companies.

Though Fearon has profited from shorting businesses that lose their way (in fact, he tends only to short a company if he's certain it's going bankrupt), he doesn't rejoice in their demise. Instead, he uses their stories to identify six managerial errors that commonly bankrupt businesses. These are signs that a company might be on its last legs (or at least really weak ones).

Here they are:

1) Focusing only on the recent past: Fearon describes his first experience in finance: working for Texas Commercial Bank during the 1980s oil boom. As we know, that boom came to a bust, but few people were expecting the industry to tank as hard as it did. That experience taught Fearon the importance of looking back in history, past the most recent cycles, to better understand and anticipate larger supercycles.

2) Over-reliance on formulas: Fearon doesn't dislike formulas - he often uses them when analyzing a company's performance. But by putting all your faith in a formula, or a particular business strategy, he warns, you could overlook external factors or one-time events. A common misstep he sees is companies relying on unsustainable growth-through-expansion formulas.

3) Ignoring, misreading, or alienating your customers: Fearon points to the recent example of clothing retailer JC Penney scaling up their prices, bringing in higher-end merchandise, cutting out "big and tall" sizes, and ditching their coupons. In one year, sales dropped 25 percent, or $4 billion. Turns out JC Penney's customers liked things the way they were.

4) Falling victim to manias: "Believing that you can't fail is one of the best ways to do just that," writes Fearon. Often blind faith in a company comes from wider manias in the industry - health crazes that lead to a businesses like Herbalife expanding without ever revealing their ingredients, or dotcom bubbles that inflate the stocks of completely unprofitable websites.

5) Failing to adapt to industry changes: It's a sad phenomenon, but it's common. Fearon points to Blockbuster as an example: instead of pushing resources into their online services in the first decade of the 2000s, the video rental company doubled down on their physical store locations. It was a bad bet, and they declared bankruptcy in 2010.

6) Being physically or emotionally removed from your company: Whether a CEO is trying to run an electronics business from thousands of miles away, or looking down on his timber company's operations from a luxurious 30th-floor office, many managers are out of touch with the businesses they run. That can lead to problems.

So keep your eyes open for this stuff.