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.

But we don't often talk about the things that can go bump in the night -- the nasty traits of some small businesses that make us fear and loathe them.

There are more than 3,900 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 Valero Energy (NYSE:VLO) and Human Genome Sciences (NASDAQ:HGSI). Just 15 years ago, these were small caps, but after multibagger returns, they're now worth billions.

But let's not kid ourselves. Out of those 3,900 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 Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) can drop precipitously from their highs, you have to keep your eyes wide open. Each has rallied in current months, but their 60% drops were a jolt to investors.

Let's start with an example of what to avoid.

Case study: Charter Communications
In our active online community, a Motley Fool Hidden Gems member asked us a few years ago what we thought of Charter Communications, a broadband cable company whose chairman and largest shareholder was Microsoft co-founder Paul Allen.

The business was also substantially owned by Wally Weitz, a Nebraska-based investor greatly admired by Warren Buffett fans. Weitz found great returns in stocks such as UnitedHealth Group (NYSE:UNH).

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 at Hidden Gems, we absolutely love broken small caps 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 Securities and Exchange Commission had launched an investigation into Charter's accounting practices.
  • Heavy spending for cable infrastructure hadn't yielded sufficiently high returns.

Near the end of June 2003, Tom Gardner 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 continued to warn investors about the company nearly every month for four years.

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

What we do and don't fear
Oddly enough, we do not fear high debt in and of itself. For example, mega caps ExxonMobil (NYSE:XOM) and Johnson & Johnson (NYSE:JNJ) each have over $7 billion in debt, but they also have solid cash positions and plenty of earnings power to be able to pay off their obligations.

Nor do we fear companies that have fallen 90% from their all-time highs. Indeed, 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.

To find out which stocks we do love, simply take a free trial of Hidden Gems. Read about all the small companies that have produced market-beating returns for us thus far -- plus our top stocks to buy right now. If you don't like it, you can cancel within 30 days without paying a dime.

This article was originally published Jan. 13, 2005. It has been updated.

Rex Moore anchors the gold-medal-winning Motley Fool 4x100 three-legged sack race relay team. He owns shares of Johnson & Johnson and Microsoft. Microsoft and UnitedHealth Group are Motley Fool Inside Value picks. UnitedHealth Group is a Motley Fool Stock Advisor recommendation. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call on Microsoft. The Fool owns shares of UnitedHealth Group. The Motley Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.