Don't Buy These Stocks Today

Back in November, I ran a screen for cheap small-cap stocks with good operating metrics. Of the 284 small caps that popped up trading for less than two times book value with returns on equity north of 15%, 27 were banks. That list included Corus Bankshares (Nasdaq: CORS) and FirstFed Financial (NYSE: FED).

But there was 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 was the problem with small banks being cheap? Frankly, I didn't want to own them.

The problem with cheap small banks
Here's a startling fact about those aforementioned 27 small, cheap banks: As of November, they were down more than 30% on average in 2007. The financial sector large and small had been sledgehammered in 2007, and even former stalwarts Citigroup (NYSE: C), AIG (NYSE: AIG), and Wachovia (NYSE: WB) had taken it on the chin due to the slowdown in the housing market and the specter of widespread defaults in the formerly overheated subprime loan market.

Then you had massive write-offs at Citigroup and Merrill Lynch (NYSE: MER), which resulted in both getting new CEOs. In other words, there was a ton of risk alongside myriad unknown variables.

Excuse me while I ... state the obvious
That industry carnage was the reason why small-cap banks looked cheap, but I'm very glad I wasn't buying. Since November Corus has cut its dividend and increased its loan loss provisions, and the stock is down 20%. First Fed is down nearly 60%.

Yet even though these stocks have gotten cheaper, I'm still not buying. 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. And even though interest rates have been cut to the brink, the credit market remains tight. 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 in the fall, "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 we see the housing sector start to rebound, 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 nearly five years ago, our picks are more than 25 percentage points ahead of the market, and there is no obligation to subscribe.

This article was first published 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.