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 7,000 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 businesses such as Urban Outfitters (NASDAQ:URBN), which has climbed 20 times in value over just the past five years, turning a $5,000 investment into $100,000.

Those who knew about this specialty retailer and jumped in after proper research were well rewarded. That's a classic Peter Lynch investment.

But let's not kid ourselves. Out of those 7,000 companies, there are also tons of mediocre firms, 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. When even solid companies like Cisco (NASDAQ:CSCO) can drop precipitously from their all-time highs (more than 80% from peak to trough), 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 university community, a Hidden Gems member asked us more than a year 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 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 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) is more than $18 billion.
  • Net debt is 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 above $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. Today, Charter trades under $1.10 per share, marking a more than 60% decline during a period in which the S&P 500 has risen some 25%.


What we do and don't fear
Oddly enough, our Hidden Gems team does not fear -- in and of itself -- high debt. Our recommendation Hooker Furniture (NASDAQ:HOFT) is carrying $23 million in debt, yet the stock has risen some 20% since the 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 90% from their all-time highs. Audible, which Rex found and wrote about, had fallen nearly to zero before turning around and showering its owners in newfound wealth. eBay (NASDAQ:EBAY) and Dell (NASDAQ:DELL) both showed significant losses after the bubble popped in 2000, but investors who saw the value in these strong, beaten-down companies have been rewarded nicely. Remember how the Tylenol scare in the 1980s created an artificially low price for Johnson & Johnson (NYSE:JNJ)?

Heck, even hints of SEC investigations can create attractive bargains on occasion. One of our favorite present recommendations is a company that just settled with regulators for mistakenly billing Medicare. We believe it could be a multibagger in the years to come. After a 2002 SEC investigation into the company's revenue-booking policies, Halliburton (NYSE:HAL) has rebounded from a similar setback.

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. The numbers just didn't add up, and we're still very wary of the stock.

To find out which stocks we do love, simply take a free trial to Hidden Gems. Read about all the many small companies that have thus far produced average 32% returns for us, vs. 12% for the same amounts invested in the S&P 500. 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. Rex owns shares of Microsoft, Audible, and eBay. Tom owns shares of Microsoft, Johnson & Johnson, and Cisco. eBay and Dell are Motley Fool Stock Advisor recommendations. Microsoft is a Motley Fool Inside Value recommendation. The Motley Fool has adisclosure policy.