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.

3,500 and counting
There are more than 3,500 public companies capitalized at less than $500 million. Sure, there are loads of great winners in that bunch, companies poised to rise many times in value. Look back and you'll find businesses such as Symantec (NASDAQ:SYMC). Buying this software company 17 years ago would have given you a 13-bagger. Now that's a classic Peter Lynch investment.

But let's not kid ourselves. Out of those 3,500 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 AIG (NYSE:AIG) can drop precipitously from their all-time highs (as each did a few years back), you have to keep your eyes wide open. Even the bluest of blue chips can hit a rough patch, as General Electric (NYSE:GE) did when it lost more than 60% of its value during the 2001-2002 bear market.

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 a few years back what we thought of Charter Communications, a broadband cable company whose chairman and largest individual shareholder is Microsoft co-founder 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 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 back then 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 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 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 quite a rollercoaster since, and now sits at $2.70.)

What we do and don't fear
Oddly enough, our Hidden Gems team does not fear high debt in and of itself. One of our recommendations, Middleby carried more than $100 million in debt after buying a competitor and repurchasing founder shares. Yet the stock has risen more than 650% since the original recommendation, and we remain very optimistic about its future. And the company's operations are strong enough to repay its obligations.

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

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 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 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 of Hidden Gems. Read about all of 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 does not own shares of any company mentioned in this article. Rex owns shares of Microsoft and Audible. Symantec, First Marblehead, and Microsoft are Inside Value recommendations. Bank of America is an Income Investor selection. The Motley Fool has a disclosure policy.