Don't Buy These Stocks Today

Run a screen for cheap small-cap stocks with good operating metrics, and you'll find a fair number of banks. Indeed, of the 284 small caps trading for less than two times book value with returns on equity north of 15%, 27 are banks. That list includes Corus Bankshares (Nasdaq: CORS) and FirstFed Financial (NYSE: FED).

But there's a problem.

Why small and cheap is good
All investors should seek out cheap small caps with good operating metrics. These stocks can provide outsized returns to long-term investors to the tune of more than 5 percentage points per year.

Sound small? In 25 years, those five percentage points make a $250,000 difference on a $10,000 initial investment.

So what's the problem with small banks being cheap? Frankly, I don't want to own them.

The problem with cheap small banks
Here's a startling fact about those aforementioned 27 small, cheap banks: They're down more than 30% on average, year to date. And with good reason: The financial sector has been sledgehammered in 2007.

The Dow Jones U.S. Financial Sector Index is down 15% this year. Core positions in that index, including Citigroup (NYSE: C), AIG (NYSE: AIG), and Wachovia (NYSE: WB), have fared far worse. The culprit? The credit crunch wrought by the slowdown in the housing market and the specter of widespread defaults in the formerly overheated subprime loan market.

Of course, you may have already heard about that.

After announcing enormous write-offs, both Citigroup and Merrill Lynch (NYSE: MER) are getting new CEOs, and some formerly strong businesses like E*Trade Financial (Nasdaq: ETFC) -- a company that still runs a fine brokerage -- look like they could be crippled by some mortgage banking debacles.

Excuse me while I ... state the obvious
That industry carnage is the reason why small-cap banks look cheap. Still, I'm not buying ... yet. Here's why:

1. With so many writedowns happening in the industry, it's hard to know which stated book values you can trust. While a multinational like Citigroup can recover from a massive writedown, a substantial writedown at a small bank could put it out of business.
   
   
2. There's no near-term catalyst. Although I believe the economy is stronger than what's being reported across most of the media, I don't see a quick turnaround in housing. That means slower growth and an unresponsive market.
   
   
3. Because it's the end of the year, and these stocks have turned in substantial losses in what has otherwise been a recent bull market, we're staring down some selling pressure as investors look to claim losses for tax purposes. There's just no reason to fight against that headwind.

Early is wrong
Now, if you also like cheap stocks (and tallyho if you do), you're ready to tell me to stop looking a gift horse in the mouth, to take cheap when I can get it, and to get ready to buy more if the banks I should be buying today fall further.

That's fine and dandy in theory, but as master money manager Ron Muhlenkamp reminded me when I shared these same thoughts with him last week, "If you're two years early, you're one-and-a-half years wrong."

It's neither fun nor profitable to be one-and-a-half years wrong.

Of course, Mr. Muhlenkamp also helped me put my thoughts in perspective. "The purpose of screens," he said, "is to get you to ask the right questions. You're doing that. A time will come when you want to own them."

Disciplined investing means waiting for that time
In other words, here's what I know:

1. Small banks look cheap.
2. I don't want to own them.
3. If they still look cheap when I want to own them, it will be time to back up the truck.

That time will come when the pressure of tax-loss selling is gone, a catalyst starts to materialize, and balance sheets look reliably, well, reliable. While that may be asking too much, as Warren Buffett has said, there are no "called strikes" in investing.

There's good news, though: Recent market volatility means that there are cheap small caps with good operating metrics outside the banking industry, and our Motley Fool Hidden Gems small-cap investing team has our eye on a good number of them. To see the stocks we're recommending today, click here to join Hidden Gems free for 30 days. Since inception four years ago, our picks are more than 30 percentage points ahead of the market, and there is no obligation to subscribe.

Tim Hanson does not own shares of any company mentioned. The Fool's disclosure policy reveals all positions when they exist ... including the naked straddle.