Veteran Motley Fool Hidden Gems members know what we love to find in a small company. Honest, competent management. Solid financials. High levels of insider ownership. Strong returns on equity and assets. Little or no Wall Street coverage. And a price that's right for long-term buyers.
What we don't often talk about, though, are the things that can go bump in the night. The traits of bad small businesses that make us fear and loathe them.
Nearly 4,000 public companies trading on the major U.S. exchanges are capitalized at less than $500 million. And sure, there are loads of great winners in that bunch, poised to rise many times in value. Look back, and you'll find companies such as clothing retailer Chico's (NYSE: CHS ) , which has climbed more than 8,700% in value over just the past 10 years, despite having a horrible 2006. (There may be hope for the company in 2007.)
That's a classic Peter Lynch investment.
But let's not kid ourselves. Out of those nearly 4,000 companies, there are tons of mediocre companies, and worse. Like Tolkien's terrible dragon, Smaug, they can incinerate your savings in no time. (Hey, we said this was scary stuff!) Quite seriously, if you're not doing business research and you don't know what to avoid out there, you could lose your fortune.
Let's start with an example of what to avoid.
Case study: Charter Communications
In our active online university community, a Hidden Gems member asked us a few years ago what we thought of Charter Communications, a broadband cable company whose chairman and largest shareholder is Microsoft (Nasdaq: MSFT ) co-founder Paul Allen. The business is also substantially owned by Wally Weitz, a Nebraska-based investor whom Warren Buffett fans greatly admire.
Charter stock had fallen from $25 to $4.50, and our member wanted to know whether it was a good time to invest for a turnaround.
We'll start by saying that in Hidden Gems, we absolutely love the broken small cap that's poised for a turnaround. Show us a company whose stock has fallen 90% from its highs, whose chairman is a billionaire, and whose largest institutional owner is a close friend of Warren Buffett, and we'll sign up to do very careful research. That's exactly what we did with Charter Communications at $4.50.
But we did not like what we found. Here's why we warned back then against investing in this business:
- Massive debt. Net debt (debt minus cash) was more than $18 billion.
- Net debt was 28 times the company's market cap of $640 million.
- Charter was unprofitable under generally accepted accounting principles, with $1.5 billion in yearly interest costs.
- Debt covenants posed a serious threat to the company's survival.
- The SEC had launched an investigation into Charter's accounting practices.
- Heavy spending for a cable infrastructure hadn't yielded high enough returns.
Near the end of June 2003, I (Tom) wrote negatively about this stock when it was trading at more than $4. It's tough to go contrary to Paul Allen and Wally Weitz. But there was no turnaround in sight, and the company's balance sheet was cratering. Charter itself cratered, dropping to less than $1 per share. 2006 turned out to be a great year for its shareholders, however, and the stock now sits at $3.20.
What we do and don't fear
Oddly enough, our Hidden Gems team does not fear -- in and of itself -- high debt. Our recommendation Middleby (Nasdaq: MIDD ) carried more than $100 million in debt after buying a competitor and repurchasing founder shares. Yet the stock has risen 475% since the original recommendation, and we remain very optimistic about its future. The company's operations are plenty strong to repay its obligations.
Nor do we fear companies that have fallen 90% from their all-time highs. Audible (Nasdaq: ADBL ) , which Rex found and wrote about, had fallen nearly to zero before turning around and drowning its owners in newfound wealth.
Heck, even hints of SEC investigations can create attractive bargains on occasion. Companies as varied as American Express (NYSE: AXP ) and Tyco have rebounded nicely from similar setbacks. The ongoing stock-option backdating scandal might provide more examples; Applied Micro Circuits (Nasdaq: AMCC ) dipped almost 25% when its news broke, and has since rebounded with a vengeance.
Each of these factors individually could make for a compelling investment as the stock price drops into the real value range.
So what was the problem with Charter Communications? The answer is the scale of its debt, running north of $18 billion, alongside harsh payment terms and emerging accounting problems.
To find out which stocks we do love, simply take a free trial of Hidden Gems. Read about all of the many small companies that have thus far produced outsized returns. If you don't like it, you can cancel within 30 days without paying a dime.
This article was originally published on Jan. 13, 2005. It has been updated.
Tom Gardner and Rex Moore anchor the gold-medal-winning Motley Fool 4x100 three-legged sack race relay team. Tom owns shares of Microsoft and American Express. Rex owns shares of Microsoft and Audible. Microsoft and Tyco are Motley Fool Inside Value recommendations. The Motley Fool has a disclosure policy.