After reading that bank-stock expert Douglas Hughes had recently called two bank buyouts that had resulted in some of the largest premiums in years, I was intrigued, and I got in touch with him. In the first part of my interview with the value-investing ace, we discussed how to pick undervalued bank stocks. Today, the man with the nose for buyouts talks about his current picks in the small- and midcap banking space. (Notes in italics are my own commentary.)

Emil Lee: Let's go over some of your current bank-stock picks.

Douglas Hughes: Some of the current banks we like? Let's start with GB&T Bancshares (NASDAQ:GBTB) -- it's growing very fast and has a great management team. If they sell the bank, it could easily fetch a 35% premium.

EL: Why do you think the management team is great?

DH: I met them on many occasions -- their track record speaks for themselves, including their [company's] growth [and lack of] non-performing loans.

EL: How do you target a 35% takeout premium?

DH: It's based on the book value, the size of their franchise, projected earnings -- sometimes, it could be off by 10%-20%. For Commercial Bankshares (NASDAQ:CLBK), we thought they'd get $42 [per share]. They got $49.

Colonial BancGroup bought Commercial Bankshares at a 32% premium.

It depends on geographies and the size of the franchise. In this market, times earnings [i.e., the P/E ratio] is more important. You could get double the valuation in a hot market.

EL: Do you study the local economy of where the bank is based?

DH: Of course. We look at the local demographics, population growth, and the economy. The most important things are a smart management team, efficiency, a growth market, and asset quality.

EL: How do you judge a bank's efficiency ratio? Is there a general rule of thumb?

A bank's efficiency ratio is non-interest expense divided by its sales (less interest expense) -- the lower, the better.

DH: For efficiency, the best-run thrifts are around 20%, good commercial banks run 40%-50%, and some are up to 70%. Sometimes, the higher [the number] is, the more likely they'll get [bought out because] there's a lot of fat to cut. Sometimes, the [CEOs pay] themselves too much, or [the banks] have stupid costs -- usually, it's the salaries. When someone [buys] them out, [the salaries are] cut right out. Sometimes, only three or four top guys account for a third or more of expenses.

EL: Is there a sweet spot in terms of insider ownership levels that's most conducive to a buyout?

DH: Usually, when a management team owns 25%, that's more likely to result in a takeover. When they own 50% ore more, they can own the bank forever. In that case, the next generation might sell. We want to see good-sized [insider ownership], but not too much; otherwise, nothing's going to happen.

EL: Tell us about one of your other picks, Pennsylvania Commerce Bancorp (NASDAQ:COBH).

DH: It's the sister company of Commerce Bancorp (NYSE:CBH). It's trading at a much lower price-to-book multiple than Commerce, which is at 2.5. [Pennsylvania Commerce] is at 1.5. Pennsylvania Commerce is worth 2.5 times book. They just built a new center, which has a big training center. They have 1,000-plus employees. They have earnings power of $2.50 a share. This is a bank worth 50% more than it's trading at [currently at $28 per share] in a couple of years, when everything's going their way.

EL: So you think Pennsylvania Commerce has some untapped earnings power because of its new center?

DH: It was $17 million to build new center. That's $3 a share in cost to build. They've got deposits and loans growing 15%-20% [annually], [they have] under 20 basis points of bad loans, and their management team is as safe as they come. They're also opening four new branches -- when they decide to stop growing, their earnings power is there.

EL: How much, in general, does it cost a bank to build a new branch?

DH: To build a new branch -- we like banks that buy the land and build branches for around $1 [million] to $3 million, depending on the market.

EL: What other banks do you like?

DH: National Mercantile Bancorp (NASDAQ:MBLA) just merged with another bank; there's a little bit of arbitrage going on. Their stock's dead water until the deal closes -- that franchise is worth 50% more. Their three or four top guys own half the stock, and I think at some point they'll sell. They'll get a good franchise, get this [merger] worked out, and sell at a premium.

National Mercantile Bancorp announced a merger of equals with FCB Bancorp about half a year ago.

EL: How do you feel about the de novo branching that so many banks seem to be favoring?

De novo branching refers to bank expansion through building new branches rather than acquiring others.

DH: In this market, I don't think anybody should be expanding. They should slow down growth and save their money until real estate pricing goes down. If they're not in fast-growing markets, [banks] should not be building branches. They'll need 15%-20% [growth to justify building a de novo branch].

EL: How much in deposits per branch do you generally like to see a bank have?

DH: For deposits, we generally need a $25 million minimum and up to $75 million or more. What we like to see is $100 million [in deposits per branch] over several years -- if they can't get to $20 million, they shouldn't have done the branch.

EL: Do you see the Internet -- with its ability to give depositors easy access to switching funds to higher-cost online money markets -- a long-term competitive threat?

DH: Pennsylvania Commerce [has] the highest Internet penetration of any bank in the country. It seems like it's very hard [for Internet banks] to make money. We follow many [of those] banks -- many are losing money and are pretty much dead money. It's still about personal relationships and making the small-business loan.

EL: Any other banks you'd want to tell us about?

DH: Park National (AMEX:PRK) is at a three-year low, pays a 4% cash dividend, and recently merged with Vision Bancshares. They think they can capitalize on their markets. They're over $5 billion [in assets]. Vision was at $700 million; now they can make much larger loans. They're like a Warren Buffett bank -- they talk in plain English, simple, no bad loans, 14 P/E ratio. A bank in their market just fetched a 35%-40% premium. This bank's at a crossroads. They either get sold, or their earnings grow or hold steady -- plus you get a large dividend. We see 5% downside, 35% upside. They've also got scarcity value.

EL: What kind of ROE [return on equity] do you generally like to see?

DH: Park National's ROE is 18%. Like Buffett, we like to see the ROE over 15%. It depends on growth -- 13%-19% [is the range we look for].

EL: What do you think about Bank of Granite (NASDAQ:GRAN)?

DH: They've been in our newsletters many times. Buffett once said they're the best-run bank in the country. Their top guy retired, and they've got great asset quality -- they could fetch a 30%-40% premium. If the stock comes down 15%-20% we could add it.

EL: It seems as though their local economy troubles have tripped them up over the past couple of years. How do you look at something like that?

DH: We weigh everything -- the growth and the valuation. They could have all the growth in the world, but we have to buy at the right valuation and have to look at what's going on with the economy -- is this the price we still want to get in at? It depends on what's happening. [For Bank of Granite,] insiders own 8.5%, right around where we want to see it. There's a little bit of fat you could cut. I don't think [Granite is] for sale. It's a fairly valued bank at this level. We just look at it and watch it.

EL: Anything else you'd want to say to help out someone like myself, who is trying to learn as much as possible about investing in bank stocks?

DH: Weigh all the variables; [make sure] the management is smart; talk to people. Look for honest, straight-to-the-point [management]. Look for [a bank] with no bad loans for five, 10, or 15 years, and wait until the price is right. Do all the research. We basically know every bank in the country that is possibly a buy in the next year. We've already done all the work. With this real estate bubble, stay with the honest guys. We've seen some of the best-run banks announce fraud. You have to believe in the management team.

It's a very strange time. We saw the highest premium ever in history -- one in Florida at 3.5 times book -- whereas another [Florida bank, Coast Financial Holdings], came close to blowing up. It's a case-by-case basis, so do your homework. I can't recall seeing two record premiums and a bank blow up in the same week. We may be at an inflection point.

In conclusion ...
It was great talking to Douglas. He gave a lot of helpful pointers and many bank-stock picks to research, so we'll be looking into those banks he mentioned in the coming weeks.

For some more banking commentary, check out:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. The Motley Fool has a disclosure policy. Emil appreciates your comments, concerns, and complaints.