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 345 small caps trading for less than two times book value with returns on equity north of 15%, 39 are banks. That list includes Silver State Bancorp (Nasdaq: SSBX), Bank of the Ozarks (Nasdaq: OZRK), and First Midwest Bancorp (Nasdaq: FMBI).

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 five 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 39 small, cheap banks: They're down 22% on average since October 2007. The entire financial sector has been sledgehammered.

The Dow Jones U.S. Financial Sector Index is down 23% over the same time frame. Core positions in that index, including Freddie Mac (NYSE: FRE) and Citigroup, have fared 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 losses, Citigroup, Merrill Lynch, and Bear Stearns (NYSE: BSC) are getting new CEOs, and some formerly strong businesses look like they could be crippled by some mortgage banking debacles. Just look at Countrywide Financial's (NYSE: CFC) chart -- what was once an industry juggernaut has now fallen off a cliff.

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.

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 month, "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's also why I'm watching, but not yet buying, timeshare operator Silverleaf Resorts (Nasdaq: SVLF). Although the stock looks cheap, its average customer has a FICO score of 670 -- which means OK, but not great credit. The specter of defaults has punished the stock, but as investors, we have time to see if those defaults actually materialize.

After all, for all of these stocks, a time will come when 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 19 percentage points ahead of the market, and there is no obligation to subscribe.

This article was first published on Nov. 16, 2007. It has been updated.

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.