Constellation Software Inc. (CSU) did not sound familiar to me at all when I came across the name. I first read a few sentences about its founder and chairman, Mark Leonard. They said that he had always traveled in coach and, when only in recent years, he started to travel in business class, he stopped getting travel expense reimbursement from the company. Wouldn’t he be the kind of manager we all look for?
I become intensely interested in learning more.
Then I discovered that Constellation software, founded in 1995, had returned 30% a year since its IPO in 2005, not a small feat. It didn’t achieve this feat by creating a new market (like Amazon), and/or a breakthrough product (like Apple). It did so in the old-fashioned way, by smartly allocating its capital.
When I tried to discover something about the creator of this feat, Mark Leonard, I couldn’t find anything. The only thing I can find is that he worked in private equity for a decade before he founded Constellation Software. He is not an Ivy league graduate. Oddly enough, I cannot even find his exact age.
These facts triggered my curiosity. I went on to find more about the company.
Constellation Software is a “constellation” of small software companies that are big players in their specific verticals. You can think of it as a baby Berkshire Hathaway of software companies but with a very big difference – the acquired companies are tiny, with deal size averaged around $10 million. These companies are run by the entrepreneurs with the company headquarters providing certain resources and coaching. The criteria that Constellation Software uses to acquire companies are listed on their website.
In a nutshell, it buys exceptional businesses with outstanding managers, consistent profitability and above-average growth. They are good businesses that can be made exceptional after Constellation Software offers “coaching and resources in a number of areas including establishing values and capital allocation processes, profit-sharing programs, benchmarking against our other businesses, the chance to share best practices with other CSI companies, formal management training and ongoing mentoring.”
Like Warren Buffett (Trades, Portfolio), Mark Leonard publishes his annual letter every year in a format somewhat similar to Buffett’s but much shorter. The letters summarize his thoughts on the company. After reading all letters since 2006, I am impressed by several things.
First, he spent much time thinking about the imperfections in the operations and how to improve, all backed up by numbers. For example, Constellation Software had a program to incubate internally generated new ideas. Over the years he carefully studied the program’s cost and benefits and tried to find a balance between research efficiency and sufficient investments in internal opportunities.
Second, he is a big believer on return on invested capital (ROIC). But he also pays attention to organic growth of the company. He thinks that over the long term, the company’s intrinsic value increases approximately by ROIC plus organic revenue growth.
Third, he is forward looking. In 2008, when all things were falling apart, he maxed out his lending capability to make acquisitions.
Fourth, he aligns his interests with his investors. In his 2014 letter, he acknowledged that he would not work as many long hours as when he was younger. But he would also stop taking pay from the company. Therefore his compensation would all come from dividends and appreciation of his holdings in Constellation Software stocks. Due to his age, he ceased flying in coach but stopped getting reimbursement for his travel expenses from the company.
I am sold by what he said.
Constellation Software has a very diverse base of businesses across both the public sector and private sector. The revenue is defensive in nature. My main question about the company is, as Leonard may be approaching retirement age, how long does he want to stay on? When he ultimately leaves, can the company still be almost as good as when he ran it?
The good news is, I believe the succession issue at Constellation Software is not as big as some other companies with star managers. For example, Berkshire has a few key people, including Buffett himself, making key capital allocation decisions. At Constellation Software, due to making many deals of small sizes over the years, there are numerous deal makers, and they grow within the company. Hopefully, the team trained this way would have longevity. Constellation Software’s system of training managers and sourcing deals seems to be quite hard to imitate, and maybe it will last a while longer than usual. That would be what investors hope for.
In brief, Constellation Software is a company fun to analyze and learn from. It has been and should continue to be a long-term winner. When the market tanks, it will shine as a defensive software company with best-in-class managers in many small niche markets.
Disclosure: We do not own the stock.
