Don't Buy These Stocks Today

Run a screen for cheap small-cap stocks with good operating metrics, and you'll find a fair number of banks.

Of 350 small caps trading for less than two times book value, with returns on equity north of 15%, 30 are banks. That list includes Wilmington Trust (NYSE: WL), Frontier Financial (Nasdaq: FTBK), and Old Second (Nasdaq: OSBC).

Are any of them worth buying now?

Why small and cheap is good
All investors should seek out cheap small caps with good operating metrics. These stocks can provide outsized returns to long-term investors to the tune of more than five percentage points per year.

Sound small? In 25 years, those five percentage points make a $250,000 difference on a $10,000 initial investment.

So why wouldn't small banks be worth buying now?

The problem with cheap small banks
Here's a startling fact about those 30 small, cheap banks: They're down 16% on average since the beginning of the year. The entire financial sector has been sledgehammered.

For its part, the Dow Jones U.S. Financial Sector Index is also down 16% in 2008, with core positions in that index -- such as Goldman Sachs (NYSE: GS), Lehman Brothers (NYSE: LEH), and American Express (NYSE: AXP) -- having fared even worse. The general culprit? The credit crunch wrought by the slowdown in the housing market and the specter of widespread defaults in the formerly overheated subprime loan market that's also tainted consumer confidence, the stock market, and the debt market.

Excuse me while I ... state the obvious
Small banks have suffered along with the industry, and that's what's made them cheap.

Now, back in November, I said I wasn't buying small banks for three reasons:

That's proved to be a good call thus far. Now, however, I am getting interested in small banks because:

Early is wrong
This is not to say that small banks will see clear skies from here. So while I'm looking hard at a few names, I'm not necessarily pulling the trigger today. I need to do a thorough investigation of the balance sheet and managerial integrity of any bank I buy.

As master money manager Ron Muhlenkamp warns, "If you're two years early, you're one-and-a-half years wrong." It's neither fun nor profitable to be one-and-a-half years wrong.

Of course, Muhlenkamp also helped me put my thoughts in perspective back in November. "The purpose of screens," he said, "is to get you to ask the right questions. You're doing that. A time will come when you want to own them." That time, I think, is near.

Disciplined investing means waiting for that time
Recent market volatility means that there are cheap small caps with good operating metrics -- and not just in the banking industry. The Motley Fool Hidden Gems small-cap investing team has our eye on a good number of them.