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 companies such as PW Eagle (NASDAQ:PWEI), which has climbed nearly eight times in value in just the past five years, turning a $5,000 investment into nearly $40,000. And what exciting product does PW Eagle make? PVC pipes.

These are the mundane types of businesses that investing master Peter Lynch loved to own.

But let's not kid ourselves. Out of those 7,000 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. When even seemingly solid companies such as Qualcomm (NASDAQ:QCOM) and St. Jude Medical (NYSE:STJ) can drop precipitously from their recent highs (these companies are down 32% and 30%, respectively), 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 admired by Warren Buffett fans and who found great returns in stocks like UnitedHealth Group and WellPoint (NYSE:WLP).

Charter stock had fallen from $25 to $4.50, and our member wanted to know whether now was a good time to invest 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, 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 at $1.64 per share, marking a 60% decline during a period in which the S&P 500 has risen 35%.


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 will carry more than $100 million in debt after buying a competitor and repurchasing founder shares. Yet the stock has risen 335% 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. Oilfield services firm Baker Hughes (NYSE:BHI), for instance, climbed more than 300% after being knocked down hard in the late '90s.

What's more, even a hint of unseemly scandal can create attractive bargains on occasion. One of our current recommendations had a CEO step down after some problems, but the stock is up 97% for us. We believe it could be a multibagger in the years to come. Many companies have rebounded nicely from similar setbacks.

Each of these 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 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 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.

Tom Gardner and Rex Moore anchor the gold-medal-winning Motley Fool 4x100 three-legged sack race relay team. Tom owns no companies mentioned in the article; Rex owns shares of Qualcomm. UnitedHealth is an Inside Value and Stock Advisor recommendation. Microsoft is also an Inside Value pick. The Motley Fool has adisclosure policy.