Back at the beginning of 2008, one segment of the market was starting to look pretty darn appealing: small banks. Indeed, more than 20 small banks were trading for less than two times book value in April, while posting trailing-12-month returns on equity north of 15%. That notable list included Corus Bankshares (NASDAQ:CORS) and FirstFed Financial (NYSE:FED).

But I hope you didn't invest.

Why small and cheap is good
Both of those names -- and many more like them -- are down more than 90% 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 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 by tightening liquidity, thanks to a subprime mortgage writedown bonanza. In the asset management sector alone, previous outperformers such as Legg Mason (NYSE:LM), Calamos Asset Management (NASDAQ:CLMS), and T. Rowe Price (NASDAQ:TROW) have been hit by increasing redemptions and declining returns.

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, 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 a total wildcard.

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 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. A full review of all of our recommendations -- as well as our top picks for new money now – will be released tomorrow to members.

Already subscribed to Hidden Gems? Log in at the top of this page.

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. Legg Mason is a Motley Fool Inside Value recommendation. The Fool's disclosure policy reveals all positions when they exist.