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.

10,000 and counting
There are more than 10,000 public companies capitalized at less than $500 million. 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 Symantec (NASDAQ:SYMC). Buying this software company 16 years ago would have given you a 13-bagger -- and that's despite losing more than a quarter of its value in the past several months. Now that's a classic Peter Lynch investment.

But let's not kid ourselves. Out of those 10,000 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 seemingly solid companies such as Krispy Kreme (NYSE:KKD) and Merck (NYSE:MRK) can drop precipitously from their all-time highs because of management missteps that weren't common knowledge, 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 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 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 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 (a year ago) 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 Securities and Exchange Commission 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 here) 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 at $1.28 per share, marking a more than 65% decline during a period in which the S&P 500 has increased some 30%.


What we do and don't fear
Oddly enough, our Hidden Gems team does not fear -- in and of itself -- high debt. Our recommendation Mine Safety Appliances (NYSE:MSA) carries more than $45 million in debt, yet the stock has jumped 115% since it was recommended, and we remain optimistic about its future. The company's operations are strong enough to repay those obligations.

Nor do we fear companies that have fallen 90% from their all-time highs. Audible (NASDAQ:ADBL), which I (Rex here) found and wrote about, had fallen nearly to zero before turning around and showering its owners.

Heck, even a hint of unseemly scandal can create attractive bargains on occasion. One of our current recommendations is First Marblehead (NYSE:FMD), whose CEO stepped down after it was revealed that he had given $32,000 worth of gifts to a female executive at Bank of America (NYSE:BAC) -- one of First Marblehead's major customers. We believe it could be a multibagger in the years to come. Many companies have rebounded nicely from similar setbacks.

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. 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 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 does not own shares of any company mentioned in this article. Rex owns shares of Microsoft and Audible. Bank of America and Merck are Income Investor recommendations. Symantec and Microsoft are Inside Value recommendations. The Motley Fool has adisclosure policy.