This is the second of two articles. Read the first here.

If you’re an avid reader, you’ve probably had an occasional wish to speak with a book’s author after finishing it. One of the cool things about being a journalist is that you sometimes get a chance to do things like that.

The day after I read the last page of “Dead Companies Walking,” now my favorite business book, my chat with author and hedge fund manager Scott Fearon became one of my favorite interviews.

Scott Fearon

Fearon started his career in money management right after finishing business school in the early 1980s. In 1990, after collecting some seed money from family and friends, he opened his fund, Crown Capital Management, in Marin County, Calif. He’s currently managing only about $100 million; that’s by design, as he prefers to invest in early-stage public companies. He says the money he’s managed during his career has grown at an 11.4% compound annual growth rate.

If possible, take a look at my review of the book before reading the following edited version of my conversation with Fearon.

Summarize your approach to investing.

It’s actually very simple. You want to buy companies that are currently profitable and will be increasingly so, and to short companies that lose money. And don’t confuse the two.

Most investors tragically break that rule, and break it often. They’re tempted to buy the speculative biotech stock or the speculative turnaround at $2. We call it the lottery-ticket mentality. It’s suicide, a surefire methodology for losing your money. John Q. Public especially needs to stick to industry leaders that generate positive revenues, earnings, and cash flows. If he’s foolhardy enough to think he can short stocks — I think he should probably index his money and go to the beach — he should do so only with companies that lose money and/or have untenable debt.

My favorite anecdote in the book was about ChemTrack, which made a home test kit for cholesterol. You wrote, “There’s no way someone’s going to rush off to Walgreens, plunk down 20 bucks and then stab themselves in the finger just so they can feel guilty for overindulging.” I laughed out loud at that.

That’s probably my favorite story of all time. It capsulizes the real world. Here was a super-smart PhD who clearly had no clue about how ordinary Americans live their lives. I sat there in the CEO’s office in Palo Alto with my jaw wide open.

That’s a common situation for startups, right? An engineer or a scientist invents a product but isn’t really a business person. What’s their outlook for success?

Well, they might get lucky, but more often than not they will fail. Wall Street loves to fund a novel idea like a home cholesterol test kit. Then-FDA commissioner David Kessler was quoted as saying it was an incredible breakthrough for the American people. David Kessler doesn’t live in the real world either!

You say you’ve made as many as 1,700 visits to corporate offices. If you request a meeting with a CFO or CEO, do you generally get the meeting?

I just call. It goes like this: “Hi, I’m Scott Fearon. I’ve been running a fund for 24 years, and we only have $100 million under management, which is by design so that we can invest in smaller companies like yours. We want to learn your story but won’t take more than an hour of your time. Your stock came up on a screen we ran on Capital IQ, and your revenues and earnings are accelerating.”

Now, if those are not accelerating, I might have to start making things up, like, “You have a really fascinating story, blah blah blah.”

Do executives realize when you’re in their offices that you might be there to gain intelligence that may help you decide to short their stock?

No. In fact, I could write a book talking about all the great CFOs and CEOs who led great companies to higher levels of earnings, cash flows, and stock prices, but that’s been written about a lot. I thought [writing about shorting stocks] would be more fun and interesting.

When I call, I don’t say “hey, I also short stocks.” I think most people in business today in America know that if a guy says he’s with a hedge fund, there’s probably some short selling going on. Most people don’t have a problem with that, because they don’t assume I’m coming for that reason. And I’m not. I go in with a blank slate in my mind. Convince me why I should own your stock.

But do you go in with a game plan?

I’m looking to find what I call the four C’s. First, tell me about your customers. Not your product, your customers. Are they rich, poor, black, white, foreign, domestic, old, young, etc. Second, tell me about your competitors. Who else does this? And then, what’s your capital allocation strategy? If you generate positive cash flow, do dividends come first? Or stock buybacks? Or are you more interested in hoarding your balance sheet to make acquisitions? Or just hoarding your balance sheet?

The fourth C isn’t actually a C. It’s about margin objectives. Where are you currently on gross margin, operating margin, and net margin? And where do you want to go, and how are you going to get there? If a CFO can’t rattle off last quarter’s operating or gross profit margin, that’s not good.

What would be your best piece of advice for CFOs when talking to a potential big investor?

Tell, don’t sell. Simply tell what your business is, where it’s going, and why you’re excited about the opportunity. If you start trying to sell me, I might short your stock.

Have you learned any foundational things from CFOs, that you then used going forward?

First and foremost, leverage is a horrible two-way street. Companies that have too much debt, that live with that capital asset pricing model B.S. that they teach in business school, that’s dangerous. It’s great to be levered up, to have debt that’s two to three times your equity, when things are going great, because you can show rapid-fire revenue and earnings growth. But when things get rough, like what’s happening in the oil business right now, companies go broke. I like companies that grow without borrowed money.

Second, businesses that have some sort of roadmap for where they want to go in terms of revenues, head count, operating margins, and net profit margins are more likely to succeed than those that don’t. So I will frequently ask, how many employees are you going to have in a year, or in two years? The proper answer is, “Well we’re budgeting for X and Y, but that will move around.” The wrong answer is, “Well, if we grow we’re going to hire people.”

You wrote in your book about the societal value of shorting the stock of poorly managed companies, and how shorted companies often blame being shorted for their problems, as opposed to realizing that the problems are why they’re being shorted. But aren’t there cases where companies have been shorted by investors who didn’t understand the whole picture, to those companies’ detriment or perhaps even destruction?

I know all the short sellers in America, and it’s very rare that a company’s stock free-falls because [of short selling]. Everybody hates short sellers, but I just find that to be a goofy argument: “Oh, the short sellers are after us!”

Well, wait a minute. It’s the opportunity of a lifetime to have a couple of dumb short sellers shorting your stock. [SEC rules say] you can only short into an uptick. If the company makes progress, at some point those short sellers are going to have to buy the stock back.

We’re actually going extinct out here in short-sell land today. First, because of fewer IPOs and a continuing trend of public companies going private, there aren’t as many stocks. Second, the tax code now works against us. Third, because of low interest rates, prime brokerages began to charge short sellers a daily “negative rebate fee” to make up for the interest they used to earn by reinvesting the proceeds of short sales. Fourth, because of Sarbanes-Oxley and Dodd-Frank, there are no longer many stories about scammy accounting.

And then there’s the uptick rule, which is a unique thing. I mean, I’ve never heard anyone propose that you can only buy stock into a downtick.

You wrote that you’re suspicious of anyone claiming to have special knowledge about a stock or the market. Yet you seem to have given away a lot of knowledge for free.

I don’t think just anybody who reads this book is able to visit companies like I can, because they don’t manage $100 million. Even if I gave John Q. Public my fund today, it would be very hard to do what I do and do it well. Besides, I’m 56, and I’m not going to be doing this when I’m 66. I don’t think I’m giving away any secrets.

Why are you still doing it now?

I’m addicted. I like meeting smart people. The one thing I love most in life is ideas.

I’m very liberal on a lot of economic issues, which probably would surprise you. I love seeing industries get disrupted, because I think that benefits America. We also need to disrupt higher education, and in the worst way. Real estate too.

Are we in another tech-stock bubble today?

You don’t want to pay silly prices for rapid growers. For example, the social media space is full of silly valuations. I don’t know what someday will blow up goofy things like Pinterest and SnapChat that aren’t even public yet. Then again, I laughed when Google paid $1.2 billion for YouTube, and I’m the fool there. All I’m saying is that companies and industries often appear to be very inexpensive based on some mathematical metric a year or two before they cease to exist.

Many times that’s the first inkling that a bankruptcy might be ahead. That’s why EBITDA is a sexy number. Every stock is cheaper on a multiple of EBITDA than a multiple of EPS. You really have to get your head around the interest dollars a company pays.

Did you ever look at a company called YRC Worldwide? It had a big debt and interest problem. I just wrote a feature article about it.

Let’s see. YRC… Oh, yeah. It’s coming back to me now like a bad rash. The trucking company. It didn’t go broke, but should have. I don’t think many of us realize how helpful the Fed has been to troubled businesses, taking interest rates to zero and keeping them there for seven years.

I recently spoke with a bankruptcy attorney who said that when rates go up, a lot of troubled companies are going to go broke.

I think that’s correct. I’ve only had about 10 bankruptcies in the last four years, because one after another has been able to refinance their debt at significantly lower rates of interest. In the one down year I had with my fund, 2009, I shorted an awful lot of companies that I thought would eventually file bankruptcy and their stocks would go to zero. But in every case they were able to sell new, lower-interest bonds and push off the maturity of their balance-sheet debt.

You wrote that executives tend to be excessively optimistic and can only be objective about their companies to a certain point. Can you elaborate?

You want to believe that the future is brighter. If you believed otherwise you would have resigned. So anyone who is left, even in a troubled situation, has hope that things will get better.

We have a very optimistic culture. We tend to promote, hire, and socialize with the beaming optimist. Ronald Reagan was a super-well-respected president because he was always optimistic. Nobody wants to be told to turn down the thermostat like Jimmy Carter told us to do.

If you’re inside corporate America and you’re talking about all the things that are troubling about your own company, you’re probably not going to get promoted, and you might get shown the door. That can lead to unrealistic budgeting and hiring. We want the guy who says he can grow his division by 12%, not 5% like the other guys say they’re going to do. And then of course we allocate resources to that guy’s division and he doesn’t get it done, and we’ve got to retrench. Excessive optimism can be disruptive.

On a related theme, you also wrote that both businesses and investors overvalue competitiveness.

I think if you sat down with the most successful investors in America, guys like Warren Buffet, you’d see that they’re incredibly bright but also have no problem admitting when they’re wrong and exiting an investment position. There’s an old saying: It’s OK to be wrong, but not to stay wrong.

I’m sure they’d tell you that they don’t want to hire the executive who talks about going home and bench pressing 300 pounds and winning the tennis tournament at his country club. And that’s not a guy you want managing money, either. He’s going to blow up.

You commented several times in the book on executives’ attire, their personal styles, what their offices look like — what’s your point there?

The point is to beware of the B.S. artist, someone who is dressed over the top but doesn’t really have a grasp of the company’s numbers. I’d rather sit with the guy who’s in a sea of paper, rattling off everything about the company.

Some executives wear their class rings. What kind of guy in his 50s does that? Or wears jewelry? The only male CFO I ever met who wore an earring, his company was broke within five weeks! [Laughs.]

I was once in a company office where everybody had on what-would-Jesus-do bracelets, and there were big deer heads everywhere. And I’m like, “Whoa, this is not good.” By the way, something tells me Jesus would not wear a WWJD bracelet.

Another thought from your book: people have a tendency to perform less due diligence when doing a deal with somebody they have some kind of affinity with.

Right. As Reagan said, “Trust, but verify.” Just because you and I belong to the same country club or went to the same college, or we’re both Jewish and you happen to know Bernie Madoff, doesn’t mean you skimp on the due diligence.

Madoff had it down to a science, giving away a lot of money to Jewish philanthropies. One day a neighbor walked into my house and told me to invest with this guy. I’m not saying I’m a genius, but I picked up the documents and said, oh my God.

One, I’ve never heard of this auditor, and you claim he’s running 10 billion bucks? Two, he kicked back his performance fees to his fundraisers? I’ve never seen that. And three, when I said I wanted to meet him, my neighbor said no, he doesn’t meet with anyone. And I’m like, you mean, people give money to a guy they’ve never met?