Don't Buy These Stocks Today

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Way back in 2008, one segment of the market was starting to look pretty darn appealing: small banks. Indeed, at the beginning of last year, 39 small banks were trading for less than two times book value, while posting trailing-12-month returns on equity north of 15%. That notable list included Pacific Capital (Nasdaq: PCBC), Virginia Commerce (Nasdaq: VCBI), and Nara Bancorp (Nasdaq: NARA).

But I hope you didn't invest.

Why small and cheap is good
All three of those names -- and many more like them -- have been crushed since then. Sure, all investors should seek out cheap small caps with good operating metrics; stocks like these can provide outsized returns to long-term investors, to the tune of more than five percentage points per year. But the recent experience of small-cap banks teaches an important lesson about the difference between trailing metrics and future outlooks.

As you've probably heard on the news, the entire financial sector has been sledgehammered by tightening liquidity, thanks to a subprime mortgage writedown bonanza. Despite a modest recent resurgence, the Dow Jones U.S. Financial Sector Index is still averaging returns of negative 20% per year over the trailing 3-year period. That’s thanks to deteriorating performance at companies such as Hartford Financial Services (NYSE: HIG) and Prudential (NYSE: PRU).

Today, CEOs are (rightfully) under fire across the industry, and the landscape looks very different since Countrywide was absorbed into and Ken Lewis jettisoned from Bank of America (NYSE: BAC) and the company formerly known as Bear Stearns was passed off to JPMorgan Chase (NYSE: JPM) with the help of some implicit government backing.

Excuse me while I … state the obvious
That industry carnage is the reason why small-cap banks looked cheap back in 2008, and why they've gotten "cheaper" today. Still, I'm 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.
2. There's no near-term catalyst. Although the economy will ultimately rebound, I don't see a quick turnaround in housing or lending. That means slower growth and an unresponsive market, alongside greater government regulation of the industry.
3. Commercial real estate may be the next shoe to drop.

Early is wrong
Now, if you also like cheap stocks (and tally-ho 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."

There's good news, though: Recent market volatility means that there are cheap small caps with good operating metrics outside the banking industry. 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.

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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.