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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.

There are more than 3,500 public companies capitalized under $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 Qualcomm (NASDAQ: QCOM  ) and Potash Corp. of Saskatchewan (NYSE: POT  ) , which gained 2,273% and 1,416%, respectively, in the last 15 years.

These easy-to-understand businesses are the type that investing master Peter Lynch loved to own.

But let's not kid ourselves. Out of those 3,500 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.

According to my research, there were 570 companies valued at $20 billion or more in late 2007, before the credit crisis began to unfold. An incredible 136 of those -- nearly a quarter of them -- have lost at least 50% of their value. Besides financials like Bank of America (NYSE: BAC  ) and Fannie Mae (NASDAQOTH: FNMA  ) , that list includes the likes of Cisco (NASDAQ: CSCO  ) and Apple (NASDAQ: AAPL  ) . When even these large guys can drop precipitously from their highs, 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 is also substantially owned by Wally Weitz, a Nebraska-based investor admired by Warren Buffett fans, and someone who found great returns in stocks like UnitedHealth Group and WellPoint (NYSE: ANTM  ) .

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 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 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, 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, 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, dropping to less than $1 per share. The stock has been on a roller coaster since then, and it now sits around $0.09.

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. But the stock has risen over 145% since the original 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. 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 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 to Motley Fool Hidden Gems. Read about all 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.

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

Read/Post Comments (1) | Recommend This Article (51)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 25, 2009, at 4:51 PM, stockcommander wrote:

    There is a short list of CAPs players that have managed to remain at the top for quite some time. So it's only natural to assume that they have some inkling about what they are doing. As far as I can see they are not following your advice.

    Since I'm not a subscriber - and in all probability never will be - I'm unable to comment on the content of your work. But I would like to say that if this "teaser" is an example of your "work": You are blatantly announcing that most people are better off without your advice. Just invest in an index fund, and try to get out when the market crumbles. Analysts on the average are on their most positive note just before the market crashes - and usually quite negative when it has finally reached the bottom.

    It's rather obvious that when the major indexes fall that is only a reflection of the fall of their individual components. Why you call this incredible is rather hard to understand.

    MSFT has moved sideways - more or less confined for many years. Current management seems determined to repeat their own failures (web/search) while slaughtering the cash cow (windows) - there is a reason why people are staying with XP.

    Banks - like Bank of America - is in deep trouble, nothing new about that. They are currently emphasizing the negative trend by writing off all that "goodwill" that they have hidden in their balance sheets since the last time it was fashionable and acceptable to admit that you really had no idea about what you bought. OK - some knew what they where doing, it was fun and they personally made a bundle.

    What I find incredible is that "analysts" repeatedly references balance sheets as something trustworthy, when history shows us that the number of ways to legally "doctor" these statements is steadily increasing. The whole valuation process is suspect - and analysts worth anything has to go far beyond what just about anybody can google on the internet.

    I would be VERY surprised to find that you have actually found "the names of 3 stocks that are positioned to gain the most" bla bla bla.

    If you had - and had confidence in your find - you would be out raising money, mortgaging your house and all that; not writing a silly "teaser" like this.

    Hidden gems seems to indicate people that should dedicated to finding stocks based on careful examination of market conditions, calling attention to "rare" finds. Big stable companies does not seem to belong in this group.

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