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 3,500 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 Qualcomm (Nasdaq: QCOM) and PotashCorp (NYSE: POT), each of which gained well over 1,000% in the last 15 years.

These easy-to-understand businesses are the type that investing master Peter Lynch loved to own.

But let's not kid ourselves. Out of those 3,500 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.

There were 570 companies valued at $20 billion or more in late 2007 before the credit crisis began to unfold. An incredible 136 of those -- nearly a quarter of them -- lost at least 50% of their value at some point. Besides financials like Bank of America (NYSE: BAC) and Fannie Mae (NYSE: FNM), that list includes the likes of Cisco (Nasdaq: CSCO) and Apple (Nasdaq: AAPL). When even these large guys can drop precipitously from their highs, 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 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 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 andWellPoint (NYSE: WLP).

Charter Communications 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 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. Continued...