Dacha Strategic Metals is a small company that specializes in investing and trading rare earth elements. These elements are often required in small quantities in high-tech products. A description of the various metals and its applications can be found on the DSM site. The bull-case for DSM is very simple, the company reported the following #’s:

Assets include metal inventory and cash. At November 30, 2011, in addition to its metal inventory, which had an estimated fair market value of US$111.5 million, the Company had cash of approximately US$4.0 million for a total of US$115.5 million, or US$1.51 per share, based on 76.4 million shares outstanding, or, US$1.29 per share on a fully diluted basis of 96.8 million shares outstanding.

The share price is currently at 0.4850 CAD (approximately 0.475 USD), making it possible to buy assets with a 63% discount (fully diluted). The company discloses the NAV weekly on it’s website, and with Google it’s easy to check that the listed prices for the various elements are reasonable (spot prices can be found here or here).

Besides the huge discount there is even more good news. The company has been buying back shares, and at the end of November it reported that it has bought back 5.5M shares since June this year and that it has 1.2M shares remaining that it can buy back under the current Normal Course Issuer Bid. Given the big discount buying back shares seems to be an excellent allocation of capital, and the amount of shares they are buying back is actually the maximum that is legally possible in Canada (there is a 10% of public float/year limit).

So far it looks like we can buy a company that is shareholder friendly at a high discount to NAV, but unfortunately it’s not that simple. Just like Urbana it’s probably best to view Dacha as a closed-end fund, and the two big questions that haven’t been answered so far is: are management incentives aligned, and what are the expenses?

Expenses

In fiscal year 2011 DSM had 5.2M in expenses while the net asset value increased from 27.2M to 52M (numbers in CAD, the company switched to reporting in USD this year). This would give us an average asset value of ~40M and with 5.2M in expenses we would get a TER of ~13% (HUGE!). The picture for this year looks better though. The company had 2.57M in expenses for the first six months, keeping expenses roughly constant while NAV increased from 53M to 128M, resulting in an expense ratio of roughly 5.7%. It’s partly an issue of scale, but most of the expenses are related to management pay, and I have a hard time imagining that they really add a whole lot of value trading rare earth elements.

Management

Management has been granted a considerable amount of options in the past. In 2010 1.8M were granted with a 0.72 strike, in 2011 5.2M warrants were granted with a 0.45 strike and 0.35M options were granted in the current fiscal year with a 1.08 strike. The executive compensation is summarized in the table below:

While executive compensation is in my opinion high (especially when you consider that Stan Bharti is chairman of more companies than I can count) there are two slightly positive things. The number of warrants granted is actually based on the estimated value of these warrants, so the bigger the company the smaller the dilution. Secondly the strike price of the warrants is very close to the current share price of DSM, so if they want to make money they do have to preserve shareholder value. The potential value of the warrants is also significant compared to the base salaries; so the incentive is there.

Another positive sign is that there has been some insider buying this year in the open market. The CEO bought in September 100,000 shares for 0.628 CAD/share, not an insignificant amount compared to his base salary. But there is currently not a lot of insider ownership: as a group they own roughly 5.5M shares compared with a total of 76.4M shares outstanding.

Related party transactions

Another negative point are the various related party transactions on the balance sheet. Nothing excessively bad; but there is for example a 3M loan to a related party that seems to be bad (and management took a long time before recognizing the loss while the loan was actually already non-performing). The company also has a small investment in another related company, it loaned money from a related company in the past and it paid consulting fees to a related party.

Conclusion

DSM doesn’t seem to be the best company, and the management also doesn’t seem to be the most shareholder friendly. There are plenty of things that I don’t like, but on the other hand: the discount is at the moment very big, and it’s not all bad. There is some insider buying and the warrants do align shareholder and management interests somewhat. They also offer a bit of a margin of safety, besides the current discount, because a dropping share price would be anti-dilutive.

I have not yet made up my mind, but at the moment I’m inclined to make DSM.V a small position in my portfolio (let me know what you think!). But even if I would be more comfortable with the management I would keep the position small. Falling rare earth element prices are a significant risk and prices have been pretty volatile.

Disclosure

Currently no position in DSM.V, but might initiate a position soon

More reading

A more enthusiastic long case at Old School Value.