Q3 2024 37.04% YTD, pricing psychology in capital markets and Pinetree Capital (PNP.TO)

Disclaimer: Nothing on this site, including this page, constitutes investing advice. Please do your own due diligence.

Q3 YTD performance is 37.04%. This past quarter has been action packed. As of the time of writing, the Hang Seng Index has had one of its best weeks in history. Fed Chair Powell lowered rates for the first time after a historic rate hiking cycle. Markets have gone through depression and mania. Admittedly, my own emotions have gone through quite the journey. I am convinced more than ever that it isn't necessarily the smartest or hard working investors that do well in capital markets. Plenty of smart, hardworking investors underperform. It is the investors that can see things for what they are, without bias, and sustain equanimity in the face of the bipolar nature of markets. Unfortunately, it really is easier said than done, however.

Pricing Psychology in the Capital Markets

In a past life, I started a few companies. One of the most important things any entrepreneur has to do is price their offering and I find a lot of the thinking with respect to pricing psychology applies to the capital markets. Securities, like products/services, have a price, quality, and story. So it stands to reason that many of the quirks and bugs in purchasing behaviour exist in the capital markets as well. 

In 1976, Dutch economist Peter van Westendorp invented a technique to measure a consumer’s sensitivity to price for a given offering. The prospective customer would be asked four questions:

• At what price would you consider the product to be too expensive such that you wouldn’t consider buying it? 
• At what price would you consider the product to be too cheap such that you would feel the quality can’t be very good? 
• At what price would you consider the product to be expensive, but not out of the question, but you’d have to think about purchasing it? 
• At what price would you consider the product to be cheap, a great buy for the money?

By Levasha - Own work, CC BY-SA 4.0, Link

Ultimately, you get 4 answers which give you a good sense for how sensitive your prospect is to the price. One of the strategies I have historically used is to define customer personas and run the sensitivity test. Inevitably, based on the need, ability to pay, and so on, you get wildly different answers. For an entrepreneur, it helps answer the very important question of who the natural buyer of an offering is as well as the price that should be used. Public capital markets are an auction driven system. Meaning at any given time, the “natural” buyer is one who has presumably answered the van Westendorp price sensitivity questions and considered the security in question, cheap.

There are many other corollaries in thinking of securities like products. Most capital markets tend to reward different “product features” differently. For example, in the US, there are considerable taxes on dividends so it makes sense that a lot of investors would prefer capital allocation in favour of reinvestment or buybacks. Value that compounds without realising gains is the mathematically more optimal way for dividend tax payers.

As of the time of writing, in recent history, many Hong Kong listed equities have been trading at severe discounts to their intrinsic value. As the price of equities in Hong Kong has been very low, van Westendorp’s question of “at what price would you consider the product too cheap such that you’d feel the quality can’t be good” applies. Just as if a high end handbag were to be priced at a bargain low price, investors naturally create narratives, both real and imaginary, for why an equity’s quality is poor. However, instead of focusing on this question alone, I would argue thinking through the other van Westendorp questions as good inoculants against being artificially biassed to the downside.

Pinetree Capital Ltd. (PNP.TO)

Pinetree Capital is a tiny company (65M CAD mcap) based out of my hometown, Toronto, Canada. However, to understand Pinetree, we must first understand another incredible company, Constellation Software. The model in venture capital is often “fund companies that can grow into something huge”. The idea was, there is a lot of failure along the way, so if you win, you must win big. By contrast, there exists a class of software companies which are the absolute opposite of this. Instead of risky bets without any revenue but a large amount of potential, there are companies which are incredibly stable, that gush cash, but do not grow and in many cases shrink. Constellation Software buys these companies at very cheap prices, streamlines them, harvests their cash flows, and buys more companies with that cash flow. This model has proven to be incredibly lucrative. A $24 investment in 2007 would be ~$4300 today (Sept, 2024) representing a spectacular 179x return. They have grown from just a handful of companies to acquiring more than 100 a year. It is important to note that Constellation Software has now acquired well over a thousand companies and in the process, a vast amount of knowledge with respect to streamlining operations. On average, a Constellation Software subsidiary has a ~15% operating margin.

The CEO of Constellation Software is Mark Leonard and he has a strong claim to be one of the best capital allocators in our lifetimes. His writing and attitude towards shareholders are reminiscent of Buffett, an incredible rarity in today’s day and age. His son’s name is Damien Leonard, the CEO of Pinetree Capital. Before Damien, Pinetree Capital was previously a mismanaged company with an awful track record. As a result, it became a listed Canadian entity with a large number of tax losses that can be used to offset income in the future. Pinetree’s model is different from Constellation Software. It is similar in that Pinetree favours discounted, small, cash flow generative software businesses. But instead of buying and holding forever, Pinetree will and has sold in the past, akin to a private equity firm.

As an example, Pinetree has acquired shares in an Australian financial software company called Bravura Solutions. Pinetree first acquired shares in Bravura in 2022, when shares were trading as cheaply as 40 cents AUD/share. It had been mismanaged for some time, churning through 3 CEOs and as a result, trading at depressed levels. Not all was lost however. Bravura had achieved operating margins of 21.4%, 15.1%, 12.4% in 2020 through 2022. Pinetree’s CIO, Shezad Okhai (a former prominent Constellation Software executive), temporarily jumped ship to Bravura to right the wrongs and steer the ship in the right direction. Long story short, Bravura today trades for $1.35 AUD (11x NTM FCF) and has announced a ~75.3M AUD capital return to shareholders. Their initial investment was $7.3M. At the time of writing, their shares are worth ~$11.6M. However, Bravura still could trade at a discount to intrinsic value as their operating margins are still far from Constellation Software’s benchmark 15% as it has just recently returned to profitability. Since Damien took over Pinetree, there have been numerous wins. Going over Pinetree’s history there are at least 9 previous holdings which have received buyout offers.

You would think that a company with the lineage, potential compounding potential, and model of Pinetree could demand a significant premium. Constellation Software trades somewhere north of 50x “owner’s free cash flow”, a huge multiple that represents an extreme level of trust. Pinetree, at the time of writing, is trading at a 1.25x last reported book value at $7.41. We (as in my family) acquired shares of Pinetree at an average weighted cost of $6.55 and hope to own Pinetree for some time to come. Unfortunately as it is a very small company, it is not very liquid and this investment is likely only appropriate for smaller portfolios.