Danger! Horror! Get Out!

Veteran Fools 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 businesses that make us fear and loathe them.

There are plenty of great companies out there, sure. But there are tons of mediocre (and worse) firms. If you're not doing proper business research, and you don't know what to avoid out there, you could lose your fortune. When even long-haul outperformers such General Electric see their prices drop by two-thirds or more in a matter of weeks, you have to keep your eyes wide open.

Let's look at an example of what to avoid.

Case study: Charter Communications
In our active online community, a member asked us in 2003 what we thought of Charter Communications, a broadband cable company whose chairman and largest shareholder was Bill Gates' former partner Paul Allen. The business was also substantially owned by Wally Weitz, a Nebraska-based investor greatly admired by Warren Buffett fans.

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 we absolutely love the broken company 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, 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. We wrote negatively about the company nearly every month for five years.

The stock itself eventually cratered, and Charter Communications filed for Chapter 11 bankruptcy.

What we do and don't fear
Oddly enough, we don't fear -- in and of itself -- high debt. Nor do we fear companies that have fallen well off their all-time highs. 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. Charter carried a "not meaningful" (NM) debt-to-equity ratio because it had negative equity. Its net debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio was around 10. Its Altman-Z score had drifted below zero -- a score below 1.8 demonstrates a high likelihood of bankruptcy (a 70% chance, according to some research).

Now let's look at Charter's 2003 situation compared to the current numbers of some related companies, as defined by Capital IQ:

Data provided by Capital IQ.

This capital-intensive, high-debt industry is not for the faint of heart. The Altman-Z score alone throws five of the seven companies into the danger zone. The good news is that none of these has a net debt-to-EBITDA ratio nearly as bad as Charter's in 2003. Still, be aware of what you're getting into.

The short bottom line
So you should just short firms that carry high debt and low Alt-Z scores, right? Not so fast. You can't just go around shorting any company with an Altman-Z score below 1.8. The 30% or so that don't go bankrupt often rebound with a fury that can decimate short sellers. Some of the companies in the table above will be great investments.

You can generate big gains shorting bad stocks, however. If you're interested in more information, just enter your email in the box below. We'll send you our latest research the instant it's published, plus a brand new report, "5 Red Flags -- How to Find the BIG Short." It's free, and there's no obligation.