This time last year, when I ran a screen for cheap stocks, one market segment kept popping up over and over again: small banks. I found 27 trading for less than 2 times book value with returns on equity north of 15%, a list that included Corus Bankshares (NASDAQ:CORS) and FirstFed Financial (NYSE:FED).

But I told you not to invest, and I hope you took my advice.

Why small and cheap is good
Both of these names, and many more like them, are down significantly over the past year -- Corus and FirstFed to the tune of 90%. 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 5 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. Former stalwarts such as Citigroup (NYSE:C) and AIG (NYSE:AIG) are breaking apart and hoping for government help, while others such as Wachovia no longer exist, and companies such as American Express (NYSE:AXP) and Goldman Sachs (NYSE:GS) have fundamentally changed their business models -- converting to bank holding companies -- in order to tap government aid. It's been a brutal, brutal year.

Excuse me while I ... state the obvious
That industry carnage is the reason small-cap banks looked cheap earlier this year, and the resulting fallout is the reason 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. When a writedown can put a multinational like Citigroup in peril, you know that it can be even worse for a small bank.
  2. There's no near-term catalyst, and I don't see a quick turnaround in housing or consumer confidence. That means slower growth and an unresponsive market, alongside greater government regulation of the industry.
  3. The recent government intervention is going to take time to work.

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. We recently released a full review of all of our recommendations -- as well as our top picks for new money now.

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

Tim Hanson owns no shares of any company mentioned. American Express is a Motley Fool Inside Value recommendation. The Fool owns shares of American Express. and its disclosure policy reveals all positions when they exist.