Stay away from small-cap bank stocks.

It was nearly 18 months ago now that Tim first dished out that advice. Though those stocks 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 to (now) slightly less bad. Notwithstanding the rising tide in the market, stocks have gotten "cheaper" since then, writedowns have gotten bigger, and the federal government has thrown Hail Mary passes in the hopes of averting further crisis.

And while big financials such as Lehman, AIG, Fannie (NYSE:FNM) and Freddie, and Goldman Sachs (NYSE:GS) have dominated the headlines, small financials have been hit just as hard. In fact, it's gotten so bad that former mid-cap banks are now de facto small caps: Regions Financial (NYSE:RF) and Huntington Bancshares (NASDAQ:HBAN) have lost 70% 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 ended September 30, small financial services companies accounted for 34% of the fund'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." True to form, over the past year, small-cap value has outperformed the S&P 500 by 10 percentage points.

Let us be clear
Nonetheless, neither we nor Mr. Hulbert are predicting that we're at the start of a prolonged 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.
  • We were certainly in 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?
But Mr. 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 SPDRs (NYSE:SPY) S&P-tracking exchange-traded fund is skewed toward the largest of companies, like $95 billion telecom giant Verizon (NYSE:VZ), small-cap value indexes are heavily weighted toward the larger likes of $3.6 billion OGE Group (NYSE:OGE), 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 managers 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 any passive index fund 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 just 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 when this bear market finally turns. We offer a free 30-day trial without obligation to subscribe -- just click here to get on board 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 doesn't, either. The Motley Fool owns shares of the Vanguard Small-Cap Value ETF. The Motley Fool has a disclosure policy that has 19 minutes to spare before midnight.