In March, we invited readers to submit the names of three stocks that they believe would be strong performers over the coming year. Here, an Investing Club member discusses one of the stocks that he submitted.
Years ago I was fortunate enough to be invited to Omaha, Neb., to have lunch with Warren Buffett. As Warren sat down beside me at Gorat’s, his favourite steakhouse, I was bursting with questions. After a brief introduction, I asked, “What advice would you offer a young person starting out in the investment business?” He replied by suggesting that the most educationally rewarding experience a new investor could have was to find their own pool of capital to manage, as soon as possible. Do not wait to be given a portfolio to manage; instead, ask your friends and family to invest with you. Consider starting an investment club.
Fast-forward to today and The Globe and Mail did just that with the Globe Investing Club. This is an interactive stock-picking contest where readers are invited to submit their best investment ideas for 2023. There were hundreds of submissions. Many were household names. However, some investors suggested a little-known company called Topicus.com.
So what is Topicus, and why is it on the radar screen of some investors?
In May, 2020, software companies Topicus BV and Total Specific Solutions reached an agreement to join forces and establish a pan-European vertical market software business. Total Specific Solutions was a unit of Toronto-based Constellation Software. As part of the agreement, in February, 2021, Topicus.com was created from the two merged companies, and spun out of Constellation. This new company trades on the S&P/TSX Venture Exchange. It has no analyst coverage, yet boasts a market capitalization of more than $7-billion, making it the largest company on the Venture Exchange. It deserves a closer look.
Topicus.com is an acquirer of vertical market software companies that provide what are known as mission-critical solutions to customers who use their software. Operating predominantly in Europe, it is a conglomerate of various business units which it manages, builds and develops with no intention to sell. Following an acquisition, Topicus shares and applies best practices that they have learned over the years with their portfolio of companies.
What is vertical market software? It is software that is tailored to the specific needs and requirements of a particular industry or market segment. It is a niche product, such as health care software that is designed for hospitals and clinics to manage patient records and schedule appointments. Topicus focuses on VMS because revenue tends to be recurring, sticky and stable in nature.
In contrast to VMS, most of us are familiar with horizontal market software. HMS includes everyday applications for word processing, spreadsheets and customer-relationship management software. It is designed to be used by a much broader audience and has greater functionality for a variety of different industries.
The history of Topicus is inextricably linked to its parent and major shareholder Constellation Software. Like Constellation, Topicus uses substantially all of its free cash flow to acquire other software companies. There are two main differences between the companies:
First, Topicus has a regional focus on Europe whereas Constellation has a much broader global footprint, with more than 50 per cent of revenue coming from North America. With local teams on the ground, Topicus’s focus on Europe provides them with a competitive advantage relative to other investors who may be investing from abroad and are less familiar with the diverse languages and cultures of Europe. The second major difference is that Topicus is a fraction of the size of its parent company. It is currently about the same size that Constellation was a decade ago.
The strategy at Topicus is threefold: First it starts by offering a specific software product to the customer in a niche field. Once the customer is using the product, Topicus will begin to offer additional value-added features. Second, once experience is gained in that business, a product is developed in an adjacent market. For example, one could conceivably move from mortgage software, for example, into wealth management. There are tremendous cross-selling opportunities. The third point of the strategy is expansion into new international markets. Topicus can follow their clientele to another country. All three of these initiatives lead to both organic revenue growth and increased customer satisfaction.
At Goodreid, we invest in quality companies for the long term, and there are a number of attributes that we like about Topicus: the company has impressive returns on capital; the balance sheet is well-capitalized; and the management team comprises skilled acquirers and operators. Despite being much smaller than its parent, there are many similarities: Topicus follows the same playbook; the two companies share much of their management team; and both companies are proficient at reinvesting their cash wisely. Last, managers have a sizable personal equity stake in the business, meaning that they think like owners rather than employees. This kind of ownership mentality is critical for success.
From a valuation perspective, determining the company’s fair value can be a little tricky given the short tenure of the new public company. Nevertheless, Topicus doesn’t look cheap at 96 times trailing price/earnings and 5.1 times price/sales. In contrast, the S&P/TSX Composite Index is a relative bargain at only 13.4 times P/E and 1.8 times P/S. Constellation, by comparison, trades at 55 times P/E and 6.4 times P/S.
There is little doubt that Topicus is a high-quality company, with impressive profitability, a strong balance sheet and a management team that has demonstrated an ability to generate impressive returns. However, value is a function of two things: quality and price. Despite the obvious quality of the company, given the eye-watering multiples we would be inclined to suggest that those interested in purchasing shares exercise some patience and wait for a more attractive entry point.
Robert Gill is senior vice-president and portfolio manager with Goodreid Investment Counsel Corp. Topicus is a holding in the investment portfolios he manages.