Back at the beginning of the year, one segment of the market was starting to look pretty darn appealing: small banks. Indeed, 30 small banks were then trading for less than two times book value in March, while posting trailing-12-month returns on equity north of 15%. That notable list included Wilmington Trust (NYSE:WL), Frontier Financial (NASDAQ:FTBK), and Old Second (NASDAQ:OSBC).

But even taking into account the recent bailout bump, 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 over these past seven months. Sure, allĀ 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 thanĀ five percentage points per year. But the recent experience of small-cap banks imparts 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 this year by tightening liquidity, thanks to a subprime-mortgage writedown bonanza. Now, Goldman Sachs (NYSE:GS) is becoming a bank, Lehman Brothers is gone, and Fortune even put $44 billion American Express (NYSE:AXP) on a list of potential takeover targets.

Excuse me while I ... state the obvious
That industry carnage is the reason why small-cap banks looked cheap earlier this year 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. 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, alongside greater government regulation of the industry.
  3. The recent government intervention is not as clear-cut as many investors -- given the furious rally that ended last week -- seem to believe it is.

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.

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

Tim Hanson does not own shares of any company mentioned. American Express is a Motley Fool Inside Value recommendation. The Motley Fool owns shares of American Express. The Fool's disclosure policy reveals all positions when they exist.