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

But I hope you didn't invest.

Why small and cheap is good
See, Preferred Bank and First Midwest are down more than 60% since then, and Silver State is out of business altogether. 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. Former financial stalwarts like Capital One (NYSE:COF) and State Street (NYSE:STT) got crushed, as did businesses such as CarMax (NYSE:KMX) that made financial products just a small part of their operations.

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.
  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 wild card.

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 Nov. 16, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. The Fool's disclosure policy reveals all positions when they exist.