Is beating the pros possible? Yes! In this six-part series, Jason Del Vicario, CFA, portfolio manager, and Steven Chen, MBA, analyst, at HillsideWealth | iA Private Wealth Inc. will explain why - and how - a concentrated portfolio of global high-quality stocks gives the long-term investor the best chance to outperform both broadly diversified indexes as well as professional money managers.
“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” -Warren Buffett
“You can’t be normal and expect abnormal results.” -Jeffrey Pfeffer
In the first three articles, we presented our case as to why we feel investors who seek to outperform professional money managers and broad indexes be singularly focused on owning a concentrated portfolio of high-quality/predictable businesses.
We then outlined the framework we employ to find and analyze high-quality/predictable business models. To reiterate, we define quality as the predictable ability for a business to generate superior returns on capital over time.
Now for the fun part! The rest of the series will see us identify real businesses that we either own or are on our radar as potential candidates.
The first company we will highlight is Constellation Software (CSU-T). We have held CSU since its inception in 2014. It was our No. 1 holding in 2014 and remains our top holding today.
What does the company do? CSU is a holding company that acquires, builds and manages vertical market software (VMS) businesses on a global scale. VMS is aimed at addressing the needs of any given business withing a discernible vertical market. Think golf course management software. Alternatively, horizontal market software can be useful to a wide array of industries. Think MS Office. CSU uses the free cash flow (FCF) of the VMS businesses to re-invest in acquiring more VMS businesses which in turns leads to more FCF and a virtuous cycle: a compounding machine! To date CSU has acquired over 600 VMS businesses.
Location, history & size: CSU is based in Toronto. The company was founded in 1995 by Mark Leonard, a former venture capitalist. It has been public since 2006 and has 25,000+ employees. Market capitalization is C$55-billion.
Business discussion: CSU effectively has two businesses: VMS businesses and an acquisition engine. The moat around this VMS businesses is the stickiness of the software. Generally, VMS have limited number of competitors in each vertical, intimate knowledge of their needs and represent mission critical tools for the end customer. In addition, the cost of the software is generally small in relation to the customer’s overall cost structure. There are also a limited number of potential end customers. These dynamics keep competition low and lead to a highly recurring and predictable business model. Customer retention has remained over 90%.
Capital allocation discussion: Another attractive feature of VMS businesses is that they don’t require much (if any) CAPEX to maintain and grow their operations. This means that they throw off healthy amounts of FCF which can be distributed to shareholders or re-invested ideally at high returns on capital. CSU chooses the latter option, although they do pay a small dividend. Fortunately for shareholders, CSU has been able to deploy increasing amounts of FCF into attractive VMS targets at favourable valuations. How can they do this? Surely market participants are aware of VMS being attractive targets.
CSU isn’t the first company to employ this strategy (Jack Henry, Roper, Tyler to name a few) and until very recently there were armies of private equity firms fueled by cheap and available capital also looking to acquire and consolidate software companies. The beauty if CSU’s model lies in two key differences. First, they copy Berkshire Hathaway and seek to be permanent owners of their acquisitions. Second, their average deal size is about $5-million. While they have conducted some larger deals CSU’s bread and butter is acquiring small VMS companies directly from founders. Private equity, generally, are looking to flip businesses (not forever owners) and would rather do larger less frequent deals (more risk) than smaller more frequent transactions.
It is important to note that the perennially successful acquisition model is extremely rare in the corporate world. Most M&A activity destroys capital. Whenever we investigate or consider an acquisition-driven company we always ask about their acquisition criteria. CSU displays this on their website. Namely, they are focused on people, profitability, growth and valuation. While they have not publicly stated their hurdle rate - the minimum rate of return on an investment required by an investor - we believe for their standard small acquisitions, the rate is 30%. Recently, in 2021, they stated that for larger acquisitions the hurdle rate will be reduced; we believe to 20%. The moat(s) for this part of the business lies in the experience of conducting hundreds of acquisitions and the fact they think and behave with a long-term mindset. In combination, these two traits are very difficult for competitors to replicate. CSU estimates there are tens of thousands of potential acquisition targets leaving a long runway for future growth.
Culture: The best way to learn about CSU’s culture is to read past president’s letters. In short, they operate a meritocracy where any employee may climb the ranks based on merit. Furthermore, they operate a decentralized model where acquired companies are left on their own and not micromanaged. They foster a culture of ownership by requiring over 3000 employees to invest a portion their after-tax bonus in shares with a four-year vesting period (acquired in the open market). They boast hundreds of employees with greater than $1-million wealth in CSU shares. Mr. Leonard and the board also own a large chunk of stock, which we like to see as it aligns the interests of management, the board, employees and shareholders alike.
Financials, valuation & stock performance: The long-term performance of a company’s share price will generally mimic the payout adjusted long-term returns on invested capital of the enterprise. For example, a company with a steady Return on Equity of 25% that pays out 50% of its returns as dividends will see its share price rise about 12.5% over time. If it never paid a dividend the stock price appreciation would be 25%. We recommend reading these last two sentences a few times until they are seared into your capital allocation thinking framework! We’ll call out a few highlights from the table below:
1) Revenues have increased 36x since IPO.
2) FCF has increased 54x since IPO.
3) ROE has averaged 39% since IPO.
4) FCF has averaged 20% IPO and trending higher of late.
5) Acquisitions have risen 38x since IPO indicative they are scaling up well.
6) CAPEX as a percentage of revenues is very low; asset light!
7) Shares outstanding have never changed.
8) P/FCF has averaged 18 and is north of 30 of late.
9) Stock price has increased 90x since IPO (to end of 2022) and with recent price of $2600 has reached 100 bagger status. Share price (including dividends and spinouts) has compounded annually by more than 30% since IPO.
Bringing this full circle, we see that the ROE has averaged about 35% since the IPO while the stock price has appreciated by a similar amount. Herein lies the beauty of the high-quality and predictable business model. Find a company that has consistently produced strong returns on capital and you’ve probably got a compounding machine on your hands. We would, however, caution that current valuation is quite stretched. CSU shares, if held for the long-term, should continue to provide the patient investor an excellent risk adjusted rate of return.
Noteworthy: Mark Leonard’s salary is $1. We often look at a ratio of share wealth to income to gauge incentives. Mark’s share wealth-to-income ratio is among the highest we’ve seen. CSU has NEVER issued a single share since their IPO as highlighted in the historical table. This is very rare and demonstrates an intense focus on shareholders. Lastly, CSU used to write a quarterly letter (2008-2009) then annually (2010-2018) and now only on an ‘when there is something new to report’ basis (most recently 2021). They do not host analyst calls or conduct media interviews; rare!
CSU represents a 12% weighting in our Hillside Focus Growth ‘all equity’ model portfolio.
Risks: No business is perfect and without risk. The biggest risk would be a change in business strategy. Problems could arise if they lowered their hurdle rate further or employed a lot of debt in their acquisition strategies. In addition, one of the main reasons that CSU has been so successful is because of its leadership, particularly Mark Leonard. Mr. Leonard is 66 - let’s say young compared to Warren Buffett (92) or Charlie Munger (99), but you get our drift.
Further Learning: CSU unfortunately does not fly below the radar anymore. There are scores of excellent articles and podcasts. We list a few here:
This information has been prepared by Jason Del Vicario, Portfolio Manager, and Steven Chen, Global Analytics Associate, for iA Private Wealth Inc. Opinions expressed in this article are those of the authors only and do not necessarily reflect those of iA Private Wealth Inc. iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.