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.

But we don't often talk about the things that can go bump in the night -- the nasty traits of some small businesses that make us fear and loathe them.

There are more than 3,900 public companies capitalized at less than $500 million. Sure, there are loads of great winners in that bunch, companies poised to rise many times in value. Look back, and you'll find businesses such as Amylin Pharmaceuticals (Nasdaq: AMLN  ) -- which has racked up annualized gains of more than 20% over the past 10 years. This was a market-crushing small-cap investment.

But let's not kid ourselves. Out of those 3,900 small companies, there are tons of mediocre (and worse) companies. 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 seemingly solid companies such as Morgan Stanley (NYSE: MS  ) and Goldman Sachs (NYSE: GS  ) can drop precipitously from their recent highs (more than 65% each), 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 a few years ago what we thought of Charter Communications, a broadband cable company whose chairman and largest shareholder is Microsoft co-founder Paul Allen.

The business was also substantially owned by Wally Weitz, a Nebraska-based investor greatly admired by Warren Buffett fans. Weitz found great returns in stocks such as UnitedHealth Group (NYSE: UNH  ) 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 broken small caps 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 Securities and Exchange Commission had launched an investigation into Charter's accounting practices.
  • Heavy spending for cable infrastructure hadn't yielded sufficiently high returns.

Near the end of June 2003, Tom Gardner 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; its stock dropped to less than $1 per share. The stock has been on quite a roller coaster since then and now sits around $0.15. According to a recent Barron's article, shareholders could get wiped out as the company seeks recapitalization.

What we do and don't fear
Yet we do not fear high debt in and of itself. For example, megacaps ExxonMobil (NYSE: XOM  ) and Johnson & Johnson (NYSE: JNJ  ) each have more than $7 billion in debt -- but they also have solid cash positions and plenty of earnings power to be able to pay off their obligations.

Nor do we fear companies that have fallen 90% from their all-time highs. Indeed, 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 answer was 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 to Hidden Gems. Read about all of the small companies that have produced market-beating returns for us thus far -- plus our top five stocks to buy right now. If you don't like it, you can cancel within 30 days without paying a dime.

This article was originally published Jan. 13, 2005. It has been updated.

Rex Moore anchors the gold medal-winning Motley Fool 4x100 three-legged sack race relay team. He owns shares of Johnson & Johnson and Microsoft. Johnson & Johnson is a Motley Fool Income Investor pick. UnitedHealth Group is a Motley Fool Inside Value and Motley Fool Stock Advisor selection. WellPoint and Microsoft are Inside Value picks. The Fool owns shares of UnitedHealth Group and has a disclosure policy.


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