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 American Eagle Outfitters (NYSE: AEO) -- up almost 1,800% over the past 15 years. This was a market-crushing small-cap investment. Or homebuilder NVR (NYSE: NVR), which carried a tiny $110 million market cap in 1994, but is now worth nearly $3 billion.

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 recent highs (over 75% each, at one point), 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 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 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. 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:

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've continued to warn investors about the company nearly every month for four years now. Continued...