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.

4,000 and counting
There are more than 4,000 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 Denbury Resources (NYSE:DNR), which has gained over 1,300% in the past 10 years while exploring oil and natural gas properties in the Gulf Coast region. The biotech firm Celgene (NASDAQ:CELG) is up over 1,000%, despite the market losing 22% in that time frame.

But let's not kid ourselves. These types of winners aren't easy to find, and out of those 4,000 small companies, there are tons of mediocre (and worse!) firms. If you're not doing business research, and you don't know what to avoid out there, you could lose your fortune.

Who knew stocks such as Google (NASDAQ:GOOG), Hewlett-Packard (NYSE:HPQ), or Garmin (NASDAQ:GRMN) could lose so much so quickly during the credit crunch? This is not to mention the carnage in the financial sector that halved companies like State Street (NYSE:STT) and SunTrust Banks (NYSE:STI). At a time when even the share prices of major firms like these are extremely volatile, you really need to know what you are doing when you invest in small caps.

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, we 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 deteriorating. We've continued to warn investors about the company nearly every month for four years now.

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

What we do and don't fear
Oddly enough, our Motley Fool 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 is up about 380% since the original recommendation, 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 found and wrote about, had fallen nearly to zero before turning around and showering its owners in newfound wealth.

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 was the scale of its debt, running north of $18 billion, alongside harsh payment terms and emerging accounting problems. The recent credit crisis has shown just how important it is to have a strong balance sheet.

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.

Rex Moore contributes the Foolish 8 screens to Motley Fool Hidden Gems. He owns shares of Microsoft. Middleby is a Hidden Gems recommendation. Microsoft is an Inside Value pick. Google is a Rule Breakers recommendation. Motley Fool Options recommended diagonal calls on Microsoft. The Motley Fool has a disclosure policy.