Stay away from small-cap bank stocks.

It was nearly two years ago now that Tim first dished out that advice. Though they looked cheap at the time, writedowns were happening across the industry, making financial institutions nearly impossible to value. On top of that, the economy was showing signs of sputtering with no resolution in sight.

Not much has changed
It's hard to believe, but the current economic downturn is two years old now -- and it's gone from bad to worse. Notwithstanding the recent rising tide in the market, stocks have gotten "cheaper," writedowns have gotten bigger, and the federal government is throwing Hail Mary passes in the hopes of averting further crisis.

And while big financials such as Lehman, AIG, Fannie, Freddie (NYSE:FRE), and Bank of America (NYSE:BAC) have dominated the headlines, small financials have been hit just as hard. In fact, it's gotten so bad that former midcap banks are now de facto small caps: Marshall & Ilsley (NYSE:MI) and Zions Bancorp (NASDAQ:ZION) have lost 75% or more of their value since this crisis began in late 2007!

All of this is to say, it's still not time to start buying small-cap banks.

It may, however, be time to start looking hard at something a little off the beaten path: small-cap value.

What's the difference?
Small-cap value and small-cap banks often get conflated -- and for good reason. As Brian noted last year, the Vanguard Small-Cap Value ETF (VBR), like most small-cap value indexes, has substantial exposure to small banks. For the quarter ending March 31, small financial services companies accounted for 34% of VBR's holdings.

So while you don't want to buy small-cap banks, you do want to buy small-cap value net of banks because, as Mark Hulbert noted in a New York Times article at the end of 2008, these historical outperformers "produce their most explosive gains right at the start of a bull market."

Indeed, Russell Investments recently released a report suggesting that "they could emerge as the frontrunners if the economy stages a recovery." Year to date, small-cap value has outperformed the S&P 500 by six percentage points.

Let us be clear
Nonetheless, neither we nor Hulbert are predicting that we're at the start of a bull market. Rather, we're noting that:

  • Small-cap value generally outperforms.
  • Small-cap value outperforms by a particularly wide margin coming out of a bear market.
  • This has certainly been a bear market.

And thus: Now is a good time to start buying small-cap exposure for the long term.

After all, a little exposure to this market segment gives you the chance to take advantage of this historical trend and puts you in the position for significant outperformance whenever this bear market turns for good.

What next?
Hulbert's recommended small-cap value investment vehicle, while low cost, is imperfect -- because he advised investors to "buy and hold an index fund benchmarked to the sector and to ride out the market's turbulence."

We see two main issues with that approach. First, as we mentioned previously, your run-of-the-mill small-cap value index has nearly 35% exposure to financial companies -- a sector that has been and will continue to be rocked by government intervention, regulatory changes, and low interest rates.

Second, just as the Vanguard 500 Index (FUND:VFINX) S&P-tracking fund is skewed toward the largest of companies, like $210 billion software giant Microsoft (NASDAQ:MSFT), small-cap value indexes are heavily weighted toward the larger likes of $2.6 billion Realty Income (NYSE:O), limiting the ability of smaller -- but perhaps better -- companies to have an effect on your returns.

Here's what we'd do
If you want to take advantage of this sector -- and we think you should -- then you ought to build your own diversified collection of superior small-cap value stocks that don't carry dangerous financial liabilities on their books.

That way, you can weight your portfolio toward high-quality businesses with entrepreneurial mangers who treat their shareholders with respect, rather than to either small-cap banks or the small-cap value stocks with the largest market caps, as passive index funds will do.

If that sounds appealing and you'd like some stock ideas and additional guidance on how to unearth the best in small-cap value, join our Motley Fool Hidden Gems service, which recently started building a new real-money small-cap portfolio.

You can see the team's real-money picks and position your portfolio to ride those "explosive gains" in small-cap value. We offer a free 30-day trial without obligation to subscribe -- just click here to get onboard today.

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This article was first published June 6, 2009. It has been updated.

Tim Hanson does not own shares of any companies mentioned. Brian Richards owns shares of VFINX and Microsoft. The Motley Fool owns shares of the Vanguard Small-Cap Value ETF. Microsoft is an Inside Value recommendation. The Motley Fool has a disclosure policy that has 19 minutes to spare before midnight.