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Steven Chen
Steven Chen
Articles (193)  | Author's Website |

Learning From the Canadian Serial Acquirer

We believe that investors can learn something from Mark Leonard in terms of his entrepreneurship, capital allocation, leadership and shareholder-friendliness

Canada-based Constellation Software (TSX:CSU) concentrates on acquiring and growing market-leading software businesses that develop specialized, mission-critical software solutions in various verticals.

As indicated in our previous articles, an inorganic growth strategy would usually discourage us. However, checking the past financials of the business, we are amazed to see an average return on equity of more than 40% and a compound annual growth rate of almost 40% in net profit for the last decade. No wonder the stock has considerably outperformed.

Thus, we looked into the company's filings and shareholder letters to find investing lessons from Mark Leonard, who is the founder and president of the company as well as a former venture capitalist.

A balanced focus between return and growth

“Our favorite single metric for measuring our corporate performance is the sum of ROIC and Organic Net Revenue Growth (“ROIC+OGr”).”

- 2007 Q4 President’s Letter

Leonard's favorite metric resonates with the Rule of 40, which originated among venture capitalists to gauge the healthiness of young software startups. The rationale behind it is not difficult to understand – if a company consumes too much capital to expand its business, then that growth would not be value-generative for owners. Not all growth is created equal.

Thrifty corporate culture

"I've traditionally traveled on economy tickets and stayed at modest hotels because I wasn't happy freeloading on the CSI shareholders, and I wanted to set a good example for the thousands of CSI employees who travel every month."

- 2014 President's Letter

Leonard's frugality reminds us of successful American entrepreneur Bob Kierlin of Fastenal (NASDAQ:FAST), who was also voted the cheapest CEO in America. The thrifty corporate culture at Constellation Software also reflects the fair dealing of the company with its shareholders. For instance, Leonard asked the Board to cut his salary and bonus as he felt that he was getting old and wanted a more balanced life.

Disciplined acquisition

“As we teach more people at CSI how to deploy capital, we lean on the accumulated data from our historical acquisitions to help maintain investment discipline. We have base rates for a variety of key operating metrics. Whether it is a neophyte investment champion arguing that a particular acquisition is “special”, or a senior executive being tempted by a large acquisition, we have enough data to make the discussion rational, not emotional. We all know whether the key assumptions are being pushed to the 55th or 95th percentiles of our historical distributions.”

- 2017 President’s Letter

In our view, staying disciplined to avoid overpriced acquisitions is harder than it appears. Clearly, the team at Constellation Software looks to focus on facts instead of opinions, which encourages more rational decisions.

Keep learning

“An investment only becomes a lesson if we diligently track its post-acquisition performance and take the time to analyze the outcome while the investment is still fresh in everyone’s mind. We have a process for this that we call a post-acquisition review, or “PAR”. We try to schedule the PAR’s about a year after the initial investment. The PAR’s originated as a head office led process approximately four years ago. Just over a year ago, we started delegating them down to the Operating Groups.”

-2017 President’s Letter

We think that learning from mistakes is crucial in both acquisition and minority investment domains. The post-acquisition review process at Constellation Software appears applicable to stock investors as well, in our opinion. After buying a stock, continuously look for evolvements of the business against previous thesis and assumptions.

Autonomous businesses in attractive niches

“CSI's strategy is to be a good owner of hundreds (and perhaps someday thousands) of growing autonomous small businesses that generate high returns on capital. Our strategy is unusual. Most CEO's of public companies would rather run a single big business - perhaps two or three big businesses, but rarely 200 businesses. They expect (or hope) to get above average returns on capital by pursuing economies of scale and by crushing or acquiring their smaller competition. "We are #1 in this large and growing market" is their normal aspirational paradigm. It's also a formula with which shareholders, analysts and boards are comfortable. We recognize that economies of scale, centralized management and world-class talent competing in large and growing markets can be a great business-building formula. But, it isn't what we do.

We seek out vertical market software businesses where motivated small teams composed of good people, can produce superior results in tiny markets. These markets are usually characterized by a gradually consolidating customer base, so partnering with the right clients, and helping them survive and prosper is an important part of our job. What we offer our BU Managers is autonomy, an environment that supports them in mastering vertical market software management skills, and the chance to build an enduring and competent team in a “human-scale” business.”

-2017 President’s Letter

Small markets can produce attractive returns. While economies of scale can play an important role in building a moat, Leonard pursues another dimension – the competitive niche. The results speak for themselves. Just compare the historical returns on capital between Constellation software and other technology conglomerates, including Google (NASDAQ:GOOG) (NASDAQ:GOOGL), IBM (NYSE:IBM) and Oracle (NYSE:ORCL).

Managing the share price

“In addition to our long-term sophisticated investors, we also have a second constituency of less financially oriented long-term investors, including some of our employee shareholders. Our employee bonus plan requires that all employees who make more than a threshold level of compensation invest in CSI shares and hold those shares for an average of at least 4 years. In practice, their average hold period has been much longer. We feel an enormous obligation to protect our non-professional investor constituency. One way we can do that is by trying to making sure that the stock price stays in a fair range at all times.”

- 2013 President’s Letter

Here, we enjoy learning from Leonard with respect to a valid point of concern about the share price being too low: employee interests. At the same time, a cheap valuation may encourage take-over bids, as was also described in the letter.

On the other hand, a highly-priced stock has its own issues, such as longtime shareholders selling and being replaced by less sophisticated investors (i.e. speculators), according to Leonard. It strongly appears to us that the management at Constellation Software is keen to balance interests among all stakeholders.

Founder businesses

“Our favorite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites. Founder businesses tend to be a very good cultural fit with CSI, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the CSI umbrella. We track many thousands of these acquisition prospects and try to regularly let their owners know that we'd love the chance to become the permanent owners of their business when the time is right for them. There is a demographic element to the supply of these acquisitions. Most of these businesses came into being with the advent of mini and micro-computers and many of their founders are baby boomers who are now thinking about retirement.”

- 2012 President’s Letter

What Leonard outlined here were precisely the "founder advantages." Long-term thinking, superior capital allocation and an entrepreneurial mentality, such as being purpose-driven, cost-conscious, customer-oriented, risk-taking and innovative, can all lead to a competitive edge for returns. Also, never forget the fact that shares in founder-led companies, in aggregate, beat the market by a wide margin.

A long-term orientation

“We incent managers and employees with shares (escrowed for 3-5 years) so that they are economically aligned with shareholders. In return, we need and want loyal employees… if they aren't planning to be around for 5 years, then they aren't going to care much about the outcome of multi-year initiatives, and they certainly aren't going to forego short-term bonuses for long-term profits.”

- 2011 President’s Letter

Leonard was outspoken about his preferred incentive plan for managers – restricted shares with a long-term vesting schedule. In our view, equity investors should always look for a long-term incentive plan in executives' compensation plans and its weighting compared to the fixed salary and annual bonus. We would also pay attention to the metrics to measure the management's performance. For example, a focus on sales, Ebitda, Ebit, EPS, return on invested capital, economic profit or total shareholder return could result in quite different endings for investors.

As Warren Buffett (Trades, Portfolio) often hinted, a good corporate manager has to be a good capital allocator, and a good stock picker has to be a good businessperson. We believe that CEOs and investors can all learn something from Mark Leonard in terms of his entrepreneurship, capital allocation, leadership, shareholder-friendliness and many other qualities.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any security mentioned in the article.

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About the author:

Steven Chen
Steven CHEN is a quality-focused investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected] or through LinkedIn.

Visit Steven Chen's Website

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