It's quiz time for buy-and-hold investors thinking about tiptoeing back into this market.

First, the facts: Year-to-date performance of bank stocks falls into two distinct categories:

Terrible. Perhaps no flock of turkeys (outside of technology) matches that of

J.P. Morgan Chase

(JPM) - Get Report

,

PNC Financial Services

(PNC) - Get Report

and

FleetBoston Financial

. As of Oct. 17, they were down 45%, 29% and 38% for the year, respectively.

Great. Banks like

North Fork Bankcorp

(NFB)

,

Commerce Bancorp

(CBH) - Get Report

,

Wells Fargo

(WFC) - Get Report

and

Bank of America

(BAC) - Get Report

have amazingly bucked the bear on the way to gains of 24%, 22%, 18% and 13%, respectively.

So here's my quiz question: Should long-term buy-and-hold investors buy stocks from Group A in the belief that they're cheap and bound to rise strongly in time? Or should investors buy into Group B because the stocks have momentum and the companies are clearly doing something right?

This situation isn't limited to the banking sector. In sectors all over this market, some stocks have been pounded far worse than others, while a few have prospered as their peers have plummeted. Among oil stocks, for example, Group A's

ExxonMobil

(XOM) - Get Report

is down 7% year-to-date, while Group B's

Apache

(APA) - Get Report

is up 16%. Among technology stocks, Group A's

Intel

(INTC) - Get Report

is down 55% for 2002, but Group B's

Dell

(DELL) - Get Report

is up 4%.

You can understand why a buy-and-hold investor would be attracted to the punished stocks in Group A. The logic goes that these stocks are cheap, historically speaking, and over time, they'll surely recover. And, of course, the long-term buy-and-hold investor specializes in time.

But those niggling voices of doubt wonder if these stocks are cheap for a reason and if they'll ever come back. Certainly some Group A companies have been so damaged by the bad decisions made during the bubble of the 1990s that they may never recover. Others are losing ground to less-stupid competitors every minute.

But Group B stocks show the same mixed picture. They're attractive, on the one hand, because they've got business and price momentum that demonstrates the ability to execute even in weak business conditions. But they're not cheap in most cases, and their recent outperformance raises the possibility that you could be buying at a top.

Finding the Right Stocks

So how would I answer my own question right now? By cheating, naturally. The correct answer is not to buy stocks solely from either Group A or Group B. Instead, buy the right individual stocks from each group.

And how do I propose to find the "right" stocks? By applying the time-tested fundamental methods of buy-and-hold investing. Fortunately, one of the great strengths of the buy-and-hold strategy is that conceptually it's very simple. In fact, I think you can boil it all down to just three steps. That makes the method especially useful for beginning investors -- as long as they understand that success as a long-term buy-and-hold investor depends on the quantity and quality of the research performed at each of these three steps.

1. Identify above-average long-term growth opportunities.

Because you are investing for the long term, you need to pick stocks that have a long-term growth horizon in front of them. It's generally a smart idea to match your proposed holding period for a stock with the length of the growth opportunity you project for the stock. If you're thinking about holding for five years or more, you should be able to see a growth path of at least that length for the stock.

2. Concentrate on those growth stories where management has shown the ability to turn above-average opportunity into above-average profits.

If the bubble has taught us anything, it's that growth without profitability isn't worth much in most cases. And that companies that are more profitable than their competitors can bury those other companies when times get tough.

3. Look to buy the best growth opportunity and the most profitable execution at the best price -- in other words, value.

As part of this effort, make sure you understand why some seemingly solid opportunities are going for a song. (Hint: This is the time you look at the balance sheet.)

Now let me try to apply these three steps to the banking sector.

Growth

In the 1990s, the idea was that growth in the banking business would come with size. If a bank were big enough, the theory went, it could win the biggest lending and underwriting deals, it could cross-sell products throughout its vast network of operations, and it could gain efficiencies by cutting duplicative staff.

This strategy, which I'd call growth by synergy, was behind the mergers that created

Citigroup

(C) - Get Report

, J.P. Morgan Chase, Bank of America and

Wachovia

(WB) - Get Report

, currently the nation's four largest banks.

The jury is still out on growth-by-synergy, but right now it looks like growth has less to do with raw size than with the strength of the individual franchises owned by the merged companies. For example, Citigroup's relative post-merger success owes to the strength of the company's consumer-banking business, the unit that contributed nearly 60% of the bank's profits in the third quarter.

In contrast, the merger between Chase Manhattan and J.P. Morgan hasn't fixed any of the weaknesses that existed in the businesses before the merger. J.P. Morgan is still a middle-of-the-pack corporate lender, and Chase still hasn't been able to gain traction in the equities markets.

Going forward, I'd say that there are two major growth opportunities in the banking business. One opportunity will go to the money center banks that best survive the downturn. The winners will be in a position to pick up share in underwriting and lending when the slump is over. The standout here is Citigroup.

The second opportunity is a direct result of the previous urge to merge. Newly created huge companies with disparate cultures created an opportunity for smaller banks to grab retail banking customers.

Banks that emphasized customer service have found it relatively easy to penetrate the core markets of the behemoths, which were too busy cutting costs to focus on key services and clients. In my hometown, banks such as Commerce Bank, North Fork Bank and Washington Mutual are opening beachheads in the core markets of Citigroup and J.P. Morgan Chase. But this trend isn't limited to New York.

In summary, there are two growth investment opportunities here, one based on recovery (Citigroup is the prime example), the other based on retail banking growth in large and growing territories (Commerce and North Fork).

Profitability

Return on assets -- how much money a bank makes from all its activities as a percentage of its assets -- reveals huge differences among banks right now. You can pull up the number for any banking segment using our Stock Screener.

Click here for a screen of return on assets for the money center banks.

For example, the return on assets for Citigroup is 1.5%. That seems paltry until you realize that it's twice the return on assets at Wachovia (at 0.7%) and five times the return on assets at J.P. Morgan Chase (at 0.3%).

You'll find the same huge spread at the smaller regional banks -- and return-on-asset numbers that are 20% to 40% better than Citigroup's.

Trustmark

(TRMK) - Get Report

, a bank in Mississippi, Louisiana and Tennessee, has a return on assets of 1.8%.

TCF Financial

(TCB)

, a bank in Colorado and the Midwest, shows a return on assets of 1.9%.

Fifth Third Bancorp

(FITB) - Get Report

, a Midwestern bank that has followed its customers to their winter homes in Arizona and Florida, reports a return on assets of 1.9%. North Fork, which has 190 branches in the New York metropolitan area, has a return on assets of 2.1%.

Many of these regional banks have built strategies around superior service, enabling them to attract substantial deposits from retail customers at very low cost. TCF Financial, for example, has grown its core deposits by 25% annually over the last year. Result: The bank has reduced its use of certificates of deposits to gain funds, thereby reducing its cost of capital.

Valuation -- and Bombshells

As a long-term buy-and-hold investor, you're looking for a growth opportunity with a duration that matches your holding period. So when you're looking at valuation, it makes sense to pay most attention to long-term growth rates.

It doesn't hurt to start with the easily available five-year projections of Wall Street analysts, as long as you do your own homework to double-check and modify those numbers. Computing the long-term PEG ratio (the current P/E divided by the five-year projected growth) for the stocks using that projection is a good way to begin your valuation exploration.

Here's how the numbers turn out for Citigroup and the six regional banks that I've mentioned in this story:

The next step is to understand why the market has priced these stocks where they are. For Citigroup, that's fairly simple: Investors are leery of the bank's potential exposure to problem loans in Brazil and elsewhere. They're also worried about its involvement in ongoing litigation over

Enron

, and the possibility that the company could be dragged into the telecom-collapse quagmire.

If you think those issues are overblown, then this stock is cheap in comparison to the other bank stocks on this list. Right now, I think the market is doing a reasonable job of pricing those uncertainties into Citigroup's price. I'd wait on this one, or build a position slowly at these levels so you minimize your exposure to the near-term risks.

In the case of the other banks on the list, the cheaper stocks aren't marked down because of any problems I've been able to find in their financials. North Fork, for example, showed a decline in nonperforming loans in the most recent quarter to just $14.1 million, or 0.12% of total loans. Net charge-offs for the quarter came to 0.13%. (For banks, you should look for signs of loan-portfolio trouble by checking into nonperforming loans, net charge-offs and reserves against nonperforming loans. If that reserve is high, it's a sign that the bank is being conservative, but also an indication that the bank might expect trouble ahead.)

Despite the importance of the financials, the current difference in valuations within this sector seems primarily related to the stocks' relative profile among Wall Street analysts. Commerce Bank and Fifth Third are both well-known Wall Street favorites, and their prices reflect that.

The other banks have less of a following, less of a reputation and less visibility -- not real handicaps for the patient investor willing to let earnings tell the tale in the long run.

There is one final test to throw at any banking stock right now. The current boom in mortgage refinancing is putting pressure on bank mortgage portfolios as they replace older, high-interest mortgages with newer, lower-interest paper.

Read carefully through the most recent quarterly reports to see what management is doing about this problem and how big of a problem it looks likely to be. One impressive element in TCF's most recent quarter is the way the company managed to hit its numbers despite the speed with which customers are refinancing.

I wouldn't be unhappy adding either TCF or North Fork to any long-term portfolio. And I'd certainly think about starting to build a position in Citigroup, albeit slowly. Right now, the stock looks technically shaky so it doesn't meet all

six of my rules for long-term investing in this market.

Jubak's Picks isn't a long-term portfolio; the holding period is 12 months to 18 months, but I believe in tracking my ideas, so I'll be adding TCF to that list. TCF gets a nod over North Fork on a slight advantage in valuation. I'm setting the target price at $51 a share by May 2003.

I'll use this same methodology -- but different growth stories and performance metrics -- to look for a long-term buy-and-hold candidate in the technology sector next. Look for it about three or four columns from now.