This time last year, 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 Preferred Bank (NASDAQ:PFBC), First Midwest (NASDAQ:FMBI), and Silver State Bancorp.

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 -- Preferred Bank to the tune of 75%, First Midwest 37%, and Silver State 99%. 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 Capital One (NYSE:COF), State Street (NYSE:STT), and Legg Mason (NYSE:LM) are down 35%, 53%, and 70%, respectively, while Lehman Brothers has gone entirely out of business.

This is the consequence of write-offs, liquidity freezes, recapitalizations, collapsing housing and equity markets, and rising inflation …with many of these events continuing to threaten financial stocks today. And then you have government involvement, which is another entirely unpredictable variable!

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.

And 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; a substantial writedown at a small bank could put it out of business.
  2. There's no near-term catalyst.
  3. All of those aforementioned unpredictable variables.

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 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, 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.

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

Tim Hanson does not own shares of any company mentioned. The Motley Fool owns shares of Legg Mason, which is also a Motley Fool Inside Value recommendation. The Fool's disclosure policy reveals all positions when they exist ... including the naked straddle.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.