Way back in 2008, one segment of the market was starting to look pretty darn appealing: small banks. Indeed, at the beginning of last year, 39 small banks were trading for less than two times book value, while posting trailing-12-month returns on equity north of 15%. That notable list included Bank of Ozarks (NASDAQ:OZRK) and Silver State Bancorp.

But I hope you didn't invest.

Why small and cheap is good
While Ozarks has handled the recent downturn relatively well and is basically breakeven after the recent rally, Silver State, and many more like it, has gone under. 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 teaches 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. This has taken down former titans of the industry, including Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Despite a modest recent resurgence and the news that some big banks are repaying TARP funds, the outlook for the industry remains questionable. Even former jewels like Moody’s (NYSE:MCO), once one of Warren Buffett’s favorite stocks, have been tarnished greatly -- and Berkshire Hathaway (NYSE:BRK-B), which once was buying all of the Moody’s it legally could, has been gradually selling some of its stake in that company.

Excuse me while I ... state the obvious
That industry carnage is the reason why small-cap banks looked cheap back in 2008, and why many still look "cheap" 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. Although the economy will ultimately rebound, I don't see a quick turnaround in housing or lending. That means slower growth and an unresponsive market, alongside greater government regulation of the industry.
  3. Commercial real estate may be the next shoe to drop.

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.

Already subscribe to Hidden Gems? Log in here.

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

Tim Hanson owns shares of Berkshire Hathaway. Berkshire and Moody's are Motley Fool Stock Advisor and Inside Value recommendations. The Motley Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy reveals all positions when they exist ... including the naked straddle.