Danger! Horror! Get Out!

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 nasty traits of some small businesses that make us fear and loathe them.

3,500 and counting
There are more than 3,500 public companies capitalized at less than $500 million on our major U.S. exchanges. Sure, there are loads of great winners in that bunch, companies that are poised to rise many times in value. Look back, and you'll find businesses such as Guess? (NYSE: GES  ) . Buying this apparel retailer five years ago would have given you a 18-bagger. Now that's a classic Peter Lynch investment.

But let's not kid ourselves. Out of those thousands of small companies, there are tons of mediocre (and worse) firms. Like Tolkien's terrible dragon, Smaug, they can incinerate your savings in no time. (Hey, we warned you 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. When even long-haul outperformers such as Whole Foods (Nasdaq: WFMI  ) and Expedia (Nasdaq: EXPE  ) can drop 20% or more in a matter of weeks, you have to keep your eyes wide open.

Let's start with an example of what to avoid.

Case study: Charter Communications
In our active online community, a Motley Fool Hidden Gems member asked us in 2003 what we thought of Charter Communications, a broadband cable company whose chairman and largest shareholder is Microsoft co-founder Paul Allen. The business is also substantially owned by Wally Weitz, a Nebraska-based investor greatly admired by Warren Buffett fans, who found great returns in stocks like Apollo Group (Nasdaq: APOL  ) and WellPoint.

Charter stock had fallen from $25 to $4.50, and our member wanted to know whether it was a good time to get in for a turnaround.

We'll start by saying that at 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, in 2003, we warned 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 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. The stock has been on a roller coaster since then, and now sits around $1.28.

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 carried more than $100 million in debt after buying a competitor and repurchasing founder shares. Yet, the stock has risen 730% since the original 2003 recommendation, and we remain very optimistic about its future. The company's operations are plenty strong to repay those obligations.

Nor do we fear companies that have fallen well off their all-time highs. Reynolds American (NYSE: RAI  ) , for instance, is up more than 350% since litigation worries in 2003, and Apple (Nasdaq: AAPL  ) has climbed over 2,000% since being hammered when the tech bubble popped a few years back.

Each of these scary 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 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 the small companies that have produced outsized returns for us thus far. 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 and Rex own shares of Microsoft. Microsoft is an Inside Value recommendation. Whole Foods is a Stock Advisor pick. The Motley Fool has a disclosure policy.

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