[00:01:39] You are listening to the Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

[00:01:59] All right, so like I said at the top, Mark Leonard is the founder and president of Constellation Software. He started the company in 1995 and he took the company public in 2006. Leonard today is around 66 years old, which is important to mention because he is just a critical piece of Constellation success as the founder and president.

[00:02:20] As I mentioned in the intro, also, Mark Leonard is a very, very interesting and unique character. There’s only two or three photos that exist of him on the internet that I can find, and there’s no interviews out there. So he’s definitely a really private person, but in the one photo that is out there, he looks like this Gandalf-type figure from the Lord of the Rings.

[00:02:41] I did manage to get access to one interview of him that is now private, but I believe it was released as a podcast and it was taken down for whatever reason. But this guy is just incredibly smart. If you want to learn more about him and understand what he is all about, then you need to read some of his shareholder letters that I’ll be pulling from during this episode.

[00:03:01] He wrote a letter every year up until 2017, but now he isn’t quite as public since there’s a lot of companies and people trying to copy and implement the business strategy that he is with Constellation. He started out in the venture capital space and his mentor named Steve Scotchmer taught him the importance of high-quality business.

[00:03:20] Some of the highest quality businesses that he could find was this VMS software model, which stands for Vertical Market Software. What he also admired from Scotchmer was a really high bar that he set for himself in the businesses that he invested in. A bar much higher than what others would tend to try and reach for.

[00:03:39] He also realized that those in the venture capital space were playing short-term games. Which really isn’t what Leonard wanted to play. He was studying the great investors such as Buffett and Munger, and wanted to play long-term games similar to them. Vertical market software businesses are essentially a type of software service that applies to a specific business or niche, whereas a horizontal software could be applied to a wide variety of different businesses.

[00:04:05] Microsoft Excel would be an example of a horizontal software solution. So, a vertical market software solution is created and customized specifically for a specific industry. Some qualities you’ll find in these businesses is high margins, higher growth, they’re asset light, they have recurring and sticky revenues, and oftentimes you’ll find that these markets are oligopolies.

[00:04:26] So there are two or three players in this specific niche that have essentially all of the market share. The revenues in a lot of these businesses are very sticky because the services they provide to their customers are absolutely essential to their operations. They’re just services that the customers and clients absolutely need to have.

[00:04:46] In his letters, Leonard talks about these VMS businesses, how they have deep customer relationships, and they continually improve their products. So, there’s a really high level of trust built with the customers that is really hard for competitors to replicate. So even if a competitor were to try and enter these niche markets with a similar product at a lower price, it wouldn’t make sense for these customers to switch to the other company because they really have no reason to, because of the trust that’s built with the existing business.

[00:05:15] And since these niche services or software solutions are a really small part of the customer’s budget, it really isn’t worth the headache for these companies to switch to another competitors. So, to sum it up, these VMS businesses are very high quality businesses. They have strong pricing power and are really businesses that Leonard is really interested in.

[00:05:34] Leonard wrote a piece about the switching costs of these VMS businesses and how the customers that are using these software just don’t even care to switch to a competitor. He writes, this is especially true for small customers where an owner operator is responsible for making the decision. These owner operators have time constraints and have to wait the return on their time from switching software vendors versus the return on their time for doing something else, anything else usually wins.

[00:06:03] Leonard saw these high-quality businesses and he was working in the venture space, and he wanted to get out of that venture line of work and get into a longer term business. The venture space is all about taking a company and dressing it up, trying to sell it off to someone else to get the return you need to get.

[00:06:19] So he figured that he would create a holding company that would specialize in acquiring VMS businesses, and that is how Constellation was born in 1995. The holding company would buy VMS business. Then those VMS businesses would create cash flow for Constellation, and then Constellation would go out and buy more VMS businesses.

[00:06:38] So it’d just rinse and repeat, go out, buy the businesses, take the cash flow, and go out and buy more businesses. And they specialize specifically in the VMS space. What is also nice about these smaller VMS businesses is that they’re able to get a high return on capital relative to purchasing very large, well-established businesses.

[00:06:57] So the venture capital players, for example, just aren’t interested in these really small businesses that are worth a few million dollars, that Constellation would be purchasing. Another unique piece with Constellation is that they were able to fix any inefficiencies in the operations through the sharing of best practices between business units.

[00:07:15] I was finding figures that they were buying these businesses at one times revenue or four times net operating profit after tax. Leonard said in his Q1 2007 letter, history suggests that we generally grow our acquired businesses, frequently providing additional products for them to sell into their installed base, and bringing our increased scale and best practices to bear upon their business.

[00:07:38] Leonard also mentioned that their favorite businesses are bought directly from founders as they tend to have the best cultures. Founders tend to really care about who they’re selling to because they care about the people they’ve hired within their business, and they want to have a parent company that will treat the employees right over the long run too.

[00:07:55] To add even more to this very favorable position in the VMS space, roughly half of Constellation’s revenues are from government agencies, which makes their subscription revenue even more sticky and less prone to disruption from their competition. Leonard wanted to create Constellation to be an enterprise that could be a permanent capital vehicle for the VMS industry, where he didn’t have to buy and sell these businesses. He wanted to buy these businesses and hold them forever, and then build relationships with managers that lasted a lifetime. Since this is a vehicle for permanent capital, he wanted businesses and managers that intended to be around for a really long time.

[00:08:32] Similar to Buffett, he puts a heavy, heavy emphasis on the management team operating at these businesses that he’s acquiring. His goal in starting the company was to be the very best acquirer of VMS businesses in the world. In his Q2 2007 letter, he states, our preference is to acquire businesses in their entirety and to own them forever.

[00:08:53] Occasionally, we have the opportunity to buy a piece of a good business with the prospect of eventually acquiring the rest.

[00:09:00] So turning back to their story, to get the holding company started in 1995, he ended up raising 25 million dollars for mainly pension funds, but also accepted some VC money as well. Usually, the VMS businesses they would purchase were directly from the founders themselves, and that naturally had just the best cultures for them.

[00:09:19] Constellation’s website states that they look for mid to large size vertical market software companies with at least 1 million in earnings before interest in tax. They also want consistent earnings and revenue growth of at least 20% per year, an experienced management team, and of course, they want the right price for the business as well.

[00:09:38] Constellation today owns over 600 of these VMS businesses, and they only ever sold one of those businesses because they were offered a really high price to which Leonard regrets. To this day, Leonard has done a ton of research on what he calls high performance conglomerates, which is an organizational structure similar to Constellation.

[00:09:57] He found 12 in particular that were the best high-performance conglomerates in the world. One of which was a company called Jack Henry, which is also in the VMS market. And then there was one more company in the VMS market as well. So, two of the 12 best performing high performance conglomerates were in the VMS market, which in my mind really goes to show that this business model of acquiring VMS businesses has shown to be a very good strategy.

[00:10:23] The way the business is set up today is that they have a small head office with six operating groups that the head office oversees. Each operating group serves as a holding company to go out and acquire these VMS businesses. Each of these operating groups is essentially what Constellation was when they first started.

[00:10:40] So today they have all these operating groups and acquirers spread out all over the world from North America, Europe, Australia, South America, and Africa. Each of these six groups operate as autonomous entities, where the business unit manager is free to make all the product and customer decisions as if they were running their own.

[00:11:00] The only difference is that since the operating groups are part of the Constellation conglomerate, they get resources and support that they wouldn’t otherwise. Interestingly, in January of 2021, they completed a spinout of one of these operating groups named Topicus. Topicus is based out of the Netherlands, which you can now buy in the public markets.

[00:11:19] Topicus is mainly focused on acquiring companies in the European market. So, if you’re interested in getting in on an early version of Constellation, which has obviously been incredibly successful to today, then Topicus is may be worth a look. When I look at the stock chart for this company in particular, it’s much more of a rollercoaster relative to Constellation.

[00:11:39] The stock is down around 50% from its all-time high, which is a drawdown that Constellation has actually never seen in its history as a public company. Topicus is essentially a carbon copy of Constellation and its current size is what Constellation was back in 2010. Topicus’s price to free cash flow is around 30, so it may be an attractive company to own if you want to own an earlier version of Constellation.

[00:12:02] There’s a couple really good write-ups on Constellation and topics on this blog called The 10th Man that I found very helpful if you’re interested in learning more and seeing more of a deep dive on both of these companies. But this episode’s going to be more focused on Constellation. Now Constellation is somewhat similar to Berkshire Hathaway in that once they acquire these businesses, they take a very hands-off approach and they put incentives in place that incentivize managers to produce high returns on capital and strong, efficient growth of revenues and earnings.

[00:12:32] So once a business is acquired by Constellation, the managers within that business are held accountable for their results, and they’re left to make what they feel is the right operating decisions within that business unit. If the managers are able to increase the cash flow margins of their business to 40%, then oftentimes they’ll get a bonus.

[00:12:50] But as far as the free cash flows go that each business generates, that for the most part gets pushed up to the capital allocators that go out and make more acquisitions. So Leonard takes this capital that the businesses generate and they go out and acquire more VMS businesses. This will then lead to more cash flow to again, be redeployed into buying more businesses.

[00:13:09] Historically, the majority of the company’s growth in revenues has been inorganic in a result of acquisitions and not really the growth in their existing business units, which I find quite interesting and really makes me question the sustainability of the model. Because a lot of the businesses they own are so small and operate in these niche markets, there really isn’t too much room for growth other than by taking share of their competitor’s market share.

[00:13:33] So looking at the maintenance revenue of their existing businesses is a pretty good barometer to assess the health of their existing companies. In 2022, Constellation acquired 134 software companies for a grand total of 1.7 billion dollars. And just for reference, their market cap today is around 37 billion US dollars.

[00:13:54] The median deal size for these deals was 3.3 million dollars, so their typical deal is pretty small. Their largest deal was actually 700 million dollars. So, there’s just much more competition in they’re having to pay a little bit higher prices. Because they’re needing to deploy more and more capital as their holding company grows, they’ve come around to doing a little bit larger deals, and they’re open to doing that going forward too. Constellation holds a database of tens of thousands of these companies that would be considered potential targets, and that list continues to grow each and every year as more and more software companies are created and enter the space with these unique software solutions.

[00:14:34] So, around 10% of Constellations revenue comes from Canada, roughly 50% from the US, 30% from Europe, and 10% from other countries. One of the things that really makes Constellation special is their culture, very similar to Berkshire Hathaway, Leonard puts intense focus and emphasis on culture. It’s a very decentralized business structure, letting people make decisions without constantly running things by upper management.

[00:15:00] And it’s a company filled with long-term thinkers. When Constellation buys these businesses, Leonard doesn’t go in and try and tell them how to run their business or tell them to cut cost to increase profitability. He just puts these incentive plans in place to allow them to run their business how they see fit.

[00:15:17] Leonard states, we seek out vertical market software businesses where motivated small teams, composed of good people, can produce superior results in tiny markets. What we offer our business unit managers is autonomy, an environment that supports them in mastering vertical market software management skills, and the chance to build an enduring incompetent team in a human scale business.

[00:15:41] Then later he states, if employees are talented, they can be quirky as long as they’re working for the greater good of the business. Priorities are clear. Systems haven’t had time to maize, rules are few, trust and communication are high, and the focus tends to be on how to increase the size of the pie and not how the pie gets divided.

[00:16:02] That’s how I remember my favorite venture investments when I was a venture capitalist, and it’s how I remember many of the early CSI acquisitions. There’s also some really great business lessons in his letters. He says, the larger a business gets, the more difficult it becomes to manage, and the more policies, procedures, systems, roles and regulations are generated to handle the growing complexity.

[00:16:25] Talented people get frustrated, innovation suffers, and the focus shifts from customers and markets to internal communication, cost control, and rule enforcement. The quirky, but talented rarely survive in this environment. A huge body of academic research confirms that complexity and coordination effort increase at a much faster rate than headcount in a growing organization.

[00:16:48] If the business unit is small enough and has a competent business unit manager who has several years of experience in the vertical and a good functional managers, then he or she will be able to cope with complexity for a while, making the right calls to optimize organic growth as a business grows. The challenge of running a business unit of this size is human scale. As a business unit becomes larger, I worry that even extraordinary, brilliant, and energetic managers who have been in the vertical and business unit for a long time and is surrounded by a team that he or she has selected and trained over many years is going to struggle to steer the business to above industry average organic growth. No one wants to admit when they’ve hit their limit.

[00:17:30] Some business unit managers lack the humility, some lack the courage, and most lack the time for reflection to notice that their task is getting too large, and the sacrifices are getting too great. This is the point at which our operating group managers and portfolio managers can provide coaching. If a large business unit is not generating the organic growth that we think it should, the business unit manager needs to be asked why employees and customers wouldn’t be better served by splitting the business unit into smaller units.

[00:17:59] Our favorite outcome in this sort of situation is that the original business unit manager runs a large piece of the original business unit and spins off a new business unit run by one of his or her protégés. Ideally, they have been grooming a promising functional manager who will be enthusiastic about running and growing its highly focused, customer-centric business unit. So clearly Leonard is very similar to Buffett and thinks a lot about business and the problems that come with continuing to scale up to be a bigger and bigger company. Leonard had studied these other great businesses who took larger business units and split them out into smaller units, one of which was a company called Illinois Tool Works Inc, which had hundreds of business units similar to Constellation. This company helps Leonard understand the huge potential of avoiding the bureaucracy that comes with size by spinning off business units to keep them relatively small at the business unit. Keeping these individual business units relatively small also keeps the entrepreneurial spirit alive as small groups have individuals that you know have the opportunity to make a big impact on their particular unit, while also having compensation incentives in place that reward them for superior performance and capital allocation.

[00:19:12] Leonard states Constellation’s resilience is bolstered further by an employee compensation plan that insulates the company if performance lags and rewards employees when the business is experiencing both high profits and rapid growth. I do firmly believe that one of Constellation’s competitive advantages is their culture and their decentralized structure.

[00:19:32] So one of the risks for investors is lose that competitive advantage as the overall business becomes larger and it potentially becomes more bureaucratic. I also think their reputation as a favorable place to sell a VMS business is another competitive advantage. Similar to the reputation of Berkshire Hathaway that they’ve built as a favorable place for founders to sell their business.

[00:19:53] Leonard writes, my motivation is to help create a company where worthy people succeed. Whether they join us with an acquisition or are hired from the outside. I want to support and encourage employees who work hard, treat others well, continuously learn and share best practices. Harder but not impossible is helping identify and remove hide bound managers who rely upon habit and folklore to run their businesses rather than rational inquiry and experimentation.

[00:20:22] Constellation is as close to meritocracy as I have experienced. I hope it will continue to provide an environment where entrepreneurs and corporate refugees can invest their lives and their capital and thrive.

[00:20:35] Now, Constellation wants to compensate their top performers very. In 2015, Leonard shared that there were more than 100 employees who had over 1 million dollars in Constellation stock and hoped to increase that number by five x by 2025, and I’m sure they’re well on their way to achieving that.

[00:20:54] The company’s employee bonus plan requires that all employees who reach a threshold level of compensation invest a portion of that compensation in Constellation stock that vests over four years. Anywhere between 25 to 75% of an employee’s after-tax bonus must be invested in shares of Constellation.

[00:21:15] And more than 3000 employees earn above the threshold for this bonus structure to kick in. And this makes for very high levels of insider ownership. So, compensation is tied to the individual and the operating group performance while wealth is largely tied to the success of the organization. This pay for performance culture is attractive to a lot of potential Constellation target companies.

[00:21:39] Insiders today own nearly 1.5 million shares of the 21 million total Constellation shares representing around 2.6 billion US dollars. In Leonard’s early letters, he also stated his goal of achieving 20% annual growth in earnings, which is quite a high bar to set. This was during the 2000s, so probably not his goal today.

[00:22:02] He says, we have publicly reiterated our revenue growth objective each quarter, and we have a bonus plan that pays for growth. Those factors create a fierce temptation to stretch a bit and make some acquisitions that aren’t quite up to par, counterbalancing, hubris, and greed. We have a good board and many long-term oriented managers.

[00:22:23] I believe that we have the judgment to maintain our investment discipline in the humility to adjust our growth objectives downwards if we don’t think that they are achievable. I’m not yet ready to concede that our net revenue growth objective is not achievable, but if we have a couple more quarters of sub 20% growth, achieving the objective will become very difficult.

[00:22:44] So really you can see his honesty and transparency coming through here where he says he’s going to try and achieve 20% growth in earnings, but he’s going to be open and honest when it’s just not possible and it’s not likely for the company. So, he is very clear with his goals, but stating, you know, we might not achieve these goals.

[00:23:01] Now to help keep this strong culture at Constellation in place, Leonard prefers to hire people from within rather than just hiring externally. Just like how he prefers his holding company and his investments to be long-term, he wants to develop long-term relationships with employees at Constellation and then compensate those employees who perform well.

[00:23:21] Leonard writes, a career path for an ambitious employee joining Constellation might be something like this, immerse yourself in learning about the specifics of VMS economics. At some point, transition from analyst or knowledge worker into a leader of people. If you make sure that the team members are intelligent, energetic, and ethical people with whom you would want to work with for the rest of your career, it won’t be long until you are running one of our business units.

[00:23:47] Whatever vertical you end up in, that specialization, that focus will require a multi-year effort to build a trusted network of employees, customers, other industry participants, and even competitors. Become a master craftsman in the art of managing your VMS business. It is the most satisfying job at Constellation, and it will generate more than enough wealth for you to live very comfortably and provide for your family.

[00:24:12] For those whose ambition exceeds their good sense, we have a role that we call a player slash coach. A player coach continues to run their business unit, but ambition drives them to acquire a sizable business, usually in another geography or another vertical. The business unit manager for the newly acquired business is nearly always from the acquisition itself, and hence has deep expertise in the vertical.

[00:24:37] Should the player coach find a second or third standalone business to acquire, they eventually have to give up the day-to-day responsibilities for running their original business unit and become a full-time portfolio manager. If the portfolio manager is good at finding acquisitions and helping them learn relevant best practices and continues to deploy at least the free cash flow produced by their portfolio, then we refer to them as a compounder, end quote.

[00:25:03] In his 2014 letter, he adds a little bit of a personal touch here. Last year I asked the board to reduce my salary to zero and to lower my bonus factor. CSI had a great year, so despite those modifications, my total compensation actually increased. This year I’ll take no salary, no incentive compensation, and I am no longer charging any expenses to the company.

[00:25:26] I’ve been the president of CSI for its first 20 years. I have waived all compensation because I don’t want to work as hard in the future as I did during the last 20 years. Cutting my compensation will allow me to lead a more balanced life with a less oppressive sense of personal obligation. I’m paying my own expenses for a different reason.

[00:25:46] I’ve traditionally traveled on economy tickets and stayed at modest hotels because I wasn’t happy freeloading on the shareholders. And I wanted to set a good example for the thousands of CSI employees who travel every month. I’m getting older and wealthier and find that I’m willing to trade more of my own cash for comfort, convenience, and speed.

[00:26:04] So I’m afraid you’ll mostly see me in the front of the plane from here on out. I love what I’m doing and don’t want to stop unless my health deteriorates or the board figures, it’s time for me to go. We have an impressive board. I trust them to determine when I’m no longer adding value as a senior executive in the company. I’m still planning to do the work I’ve always done, acquisitions, monitoring, best practice development, investor relations, and financing. I’m just not going to do the weekends, all-nighters in a constant grind of 60 hour plus weeks that characterize my early career. Now to see Leonard write this, many people will probably somewhat roll their eyes and think, this guy’s just totally full of it.

[00:26:43] But from my perspective, this is simply his way of under promising and over-delivering. It’s one thing for somebody to say this and then the company does horrible after he steps back from the company. But Constellation, since its IPO, and since this letter in 2014, has just been crushing it in terms of the actual business performance and then the stock as well.

[00:27:04] What ultimately matters is the business results, and he has continued to deliver year after year, after year. Now when you have all of these business units, you might have some sort of conflict of interest between the businesses as they may be trying to sell to similar clients, for example. To help combat that conflict of interest, Leonard provides a portion of their compensation, as I mentioned, to be bought in Constellation shares. So this helps align the interests of the individual business unit with that of the parent company Constellation. And it’s important to note that Constellation does not provide stock-based compensation, so existing shareholders are not diluted.

[00:27:42] What I also really like is that Leonard is adamant about not diluting shareholders, as the shares outstanding today are around 21 million shares, and that’s what it’s been at since its IPO. Even during the IPO, Leonard did not want to issue shares and dilute the existing shareholders. Really, the only reason that Constellation did go through the IPO process was to provide liquidity to the venture investors who won it out.

[00:28:07] The bulk of the shareholder base during the IPO didn’t really change at all. He had those long-term shareholders in place that knew what Leonard was all about, and they were in it for the long run. Leonard also tends to avoid debt, but during the great financial crisis, he actually did start taking on more debt because the deals were just so attractive and there really wasn’t much competition for those deals.

[00:28:29] I think that if Constellation sees a compelling opportunity in the near future and needs more cash to fund the deal, he could definitely utilize more debt as an option, as they have a really robust balance sheet. Constellation also reminds me quite a bit of Ray Dalio in this idea of a meritocracy in empowering the employees.

[00:28:48] Mark Leonard doesn’t ever just tell his employees or tell his managers what to do. He might suggest what he would do and why he would do it, but he encourages the team members to think for themselves and to come to their own conclusions. Leonard in the private podcast interview that I tuned into, stated that the organization becomes better when a wide variety of ideas can be tested.

[00:29:10] If Leonard were to always have the final say on a decision, then there might be bias involved and new ideas might not be brought about. The rise of new ideas is what helps make Constellation so great because there’s this experimentation happening within the business units, and best practices are shared amongst the different business units.

[00:29:29] It’s this decentralized approach where everyone can bring up new ideas, and you’re not just going to Leonard for every single idea. It makes the operation so much more efficient and it allows the best ideas to come to fruition. This creates a high degree of trust too between the management and the team members, and the focus is on growing the overall pie rather than maximizing the gain for each individual.

[00:29:52] Leonard believes that autonomy leads to a much better organization. As he states, one of the fundamental beliefs at CSI is that autonomy motivates people, and bureaucracy does the opposite. So we try to do as many of the important monitoring tasks with as light of a touch as possible. I feel like I’ve already mentioned this, but I really admire Leonard for his honesty and his transparency in his letters, which is really in line with how Buffett communicates in his shareholder letters.

[00:30:19] In past shareholder meetings, he stated that the stock was trading at too expensive of a price, and similar to Buffett, he wanted the stock to trade around its intrinsic value so that shareholders could fully benefit from the value and the cash that the business generated over time, rather than trying to talk the stock up like what many managers do.

[00:30:38] Leonard has generally worked to talk the stock price down, which in my opinion is very telling to the kind of person he is. He truly cares for and truly wants what’s best for long-term shareholders. In his 2010 letter, he states, I used to maintain that if we concentrated on fundamentals, then our stock price would take care of itself.

[00:30:59] The events of the last year have forced me to rethink that contention. I am coming around to the belief that if our stock price strays too far, either too high or too low from intrinsic value, then the business may suffer. Too low, and we may end up with the barbarians at the gate. Too high, and we may lose previously loyal shareholders and shareholder employees to more attractive opportunities.

[00:31:24] So I find that excerpt super interesting coming from Leonard. It just reminds me so much of Buffett. Leonard also points out the limitations and the reported gap earnings figures. So he wants to supplement those figures with Constellation’s own calculations of adjusted net income, average invested capital, return on invested capital, organic net revenue growth, and attrition. They need defines each of those in his letters if you’re interested in learning more about those. One of the main metrics he tracks for tracking the increase in shareholder value over a period is the return on invested capital plus the organic net revenue growth.

[00:32:02] He states in his 2009 annual letter, when we think about invested capital, we think about the shareholder capital that has been invested in the businesses, plus any adjusted net income, less any distributions. Obviously, when you divide adjusted net income by invested capital, you get a measure of the return on our shareholder’s investment.

[00:32:24] If you add organic net revenue growth to return on invested capital, you get what we believe is a proxy for the annual increase in shareholders’ value. In a capital intensive business, you couldn’t just add organic net revenue growth to return on invested capital because growing revenues would require incremental invested capital.

[00:32:45] In our businesses, we can nearly always grow revenues organically without incremental capital, end quote. Then if you fast forward to his 2017 annual letter, you’ll find that the return on invested capital plus organic net revenue growth percentage was in the 30% range year after year.

[00:33:05] From 2008 through 2017, the average for this total was 33%, which is just excellent. One other thing I really like about the management team is that they’re adamant on not dropping their hurdle rates to make it easier for them to make these acquisitions. It will end up being a decision as a group if they do decide to drop their hurdle rates, but that is one item that they are very, very hesitant to change in order to ensure the high return on invested capital going forward.

[00:33:33] Leonard provides the metrics he believes are most useful to shareholders to judge the performance of the business. Instead of earnings per share, Leonard prefers to use what he calls adjusted net income, and this makes certain adjustments for non-cash expenses such as the depreciation of intangible assets.

[00:33:51] Like I mentioned for capital allocation, Leonard points to the return on invested capital plus organic net revenue growth. Leonard states, we believe that long-term shareholders will generate a return on their Constellation shares that cannot exceed the sum of long-term return on invested capital plus organic net revenue growth.

[00:34:11] We align compensation with this belief basing our corporate bonus plan upon ROIC and net revenue growth. For those who aren’t as optimistic about Constellation stock as an investment, they say that they can assess Constellation’s ability to continue to make these highly profitable acquisitions. Once that stops or once that slows, then the business returns would likely drop substantially.

[00:34:34] Thus, your stock returns would also drop. It really goes back to the idea of the reversion to the mean and how businesses that are able to earn high returns eventually will inevitably revert back to the mean returns that most businesses earn. It’s funny because Leonard has actually mentioned this from the high performance conglomerates he studied and how a lot of these conglomerates had high returns on capital initially, and all of them eventually saw their returns diminished over time, but he didn’t say that they reverted back to the mean necessarily.

[00:35:04] As I mentioned earlier, there are tens of thousands of businesses that Constellation could potentially acquire.

[00:35:10] In an article I saw on valueinvestorsclub.com mentioned that the last reported numbers of the business in the funnel was in excess of 30,000 potential acquisitions, and it’s totally possible that’s grown substantially as of late. In 2017, Forster estimated that there were more than 100,000 independent software companies globally growing at 25% per year, which to me is just mind blowing to think how big this world really is with how many, you know, fast growing software businesses.

[00:35:39] In 2009, Leonard writes, the board also worries that if we continue with our current strategy, our growth rates may start to slow and or our profitability erode. There’s something to their observations and concerns. We have been a serial acquirer of inherently attractive small vertical market software businesses in a large number of different verticals.

[00:36:00] We try to be competent, long-term oriented owners of these businesses. Our maintenance, attrition and organic maintenance growth numbers coupled with our profitability suggest that we may have been successful. Obviously, they have been. In the vast majority of cases, the longer we have owned a small software business, the larger and better it has become.

[00:36:20] If we persist in this strategy, let’s call it the mini vertical strategy, we will continue to add new verticals and to make many more small acquisitions each year. Then a bit later, having owned more than a hundred vertical market software businesses, we also have some best practices that we can share. We coach the managers of our newly acquired businesses and how to grow their business and make them even better.

[00:36:44] As long as we compensate these managers appropriately and are not tempted to meddle too much, then I think we can scale Constellation up for many years to come. And remember, this was in 2009 and this prediction was definitely true, and Leonard, I think he just really is underselling himself and just continuing to over-deliver, which I really love to see as a potential shareholder myself.

[00:37:07] 2017 was one of the more recent letters from Leonard where he outlines all of the metrics they use to internally assess the business performance. He did send out another letter in 2021, but he didn’t provide that updated information. I believe he stated that he stopped sending out these letters because he only wanted to use them to communicate updates within the company to shareholders.

[00:37:30] But I think he’s even more private about the business nowadays because of the increased competition and more copycats. In his 2021 letter, he stated that they kept the hurdle rates high for small and mid-size VMS acquisitions and made very few exceptions for large VMS acquisitions. He also talked about how a manager was complaining to him about the occasional special dividends that Constellation paid out to shareholders, arguing that Constellation could make a higher return on that capital than the shareholders could, had they kept it in the business until they find use to deploy that capital. So, to give you some background, Constellation has paid a small dividend over time, but occasionally when they had extra cash, they would pay out these special larger dividends.

[00:38:12] So the board came to the decision to discontinue any special dividends. They also decided that their small quarterly dividend will remain in place, but if they’re successful in finding better uses of that capital, then they may also discontinue the quarterly dividend as well. Today, their yearly dividend yield is only about 0.2%, so it’s not a huge difference, and they haven’t really been increasing that quarterly dividend over the years, so it really isn’t much of a consideration for those looking at the stock.

[00:38:40] In the 2021 letter he writes, our operating group managers have done a spectacular job growing CSI’s market share of acquisitions within this portion of the VMS sector. Without succumbing to the siren song of increased centralization, bureaucracy, and control, most of these businesses are blessed with big moats and long tenured employees and customers. The operating groups provide a low overhead environment where autonomy and shared knowledge are the cultural norm and good people thrive. I am incredibly proud of what they’ve accomplished.

[00:39:14] Sensor free cash flows have grown so much over the years. Leonard has stated that they plan on increasing the number of very large VMS acquisitions that they pursue, and start developing a circle of investing competence outside of the VMS sphere. Constellation can’t just acquire very small businesses forever because eventually they just have too much money.

[00:39:34] Eventually they just have too much capital chasing too few good of deals, so they recognize that they have to expand that opportunity set, which is really great for shareholders to see a quality management team starting to look elsewhere to increase the company’s runway. Again, I see similarities between Buffett and Berkshire’s approach to buying businesses.

[00:39:53] Leonard writes, we are building a small, dedicated team at the head office to pursue large VMS acquisitions and to work with m and a brokers. If we drop our hurdle rates for these acquisitions, I believe that competent and diligent m and a brokers will include us in more auctions. Most of our competitors maximize financial leverage and flip their acquisitions within three to seven years.

[00:40:17] CSI appreciates the nuances of the VMS sector. We allow tremendous autonomy to our business unit managers. We are permanent and supportive stakeholders in the businesses that we control, even if their ultimate objective is to eventually be a publicly listed company. CSI’s unique philosophy will not appeal to all sellers and management teams, but we hope it will resonate with some.

[00:40:41] If we are successful in acquiring one or two large VMS businesses per year, then I anticipate that CSI’s return on invested capital will decrease, but we will not have to return any of our free cash flow to shareholders. This is music to a shareholder’s ears that have ownership in a business like this.

[00:40:59] So Leonard recognizes that in order to make these larger VMS acquisitions, he’s likely going to need a little bit lower of a hurdle rate because of the increased competition for these much larger deals. For their smaller deals, I believe they’re targeting return of around 20% IRR, and the larger deals are checks for written at least a hundred million dollars.

[00:41:19] That hurdle rate’s probably in the mid-teens. The 10th Man blog shared these great charts in the most recent Constellation writeup that shows the total spend on acquisitions per year, as well as the total number of acquisitions per year. Their dollars deployed is like a parabolic chart upwards increasing from just over 200 million in 2017 to over 1.7 billion in acquisitions for 2022.

[00:41:43] And then a similar story for their number of acquisitions. In 2017, they completed around 50. In 2022, they completed over 130. So in recent years, they’ve shown the ability to scale up their number of acquisitions in their total amount of capital deployed and just, I don’t see any sign of it slowing down.

[00:42:01] Their average acquisition size has increased slightly, but it’s still very small. The average deal today is around 13 million dollars. Historically, the average deal has been around 5 million dollars or less. I’ve also been reading that they’ve been continuing to expand into new countries that they’ve never made acquisition purchases in before.

[00:42:21] This includes South Africa, Singapore, Pakistan, and Japan. Down the road, I believe that they’ll be able to continue to penetrate into markets like South America, Africa, and Asia in order to continue that growth in the number of their acquisitions and expand it in new markets. I think another risk with this company is the valuations of the VMS businesses eventually increasing relative to the underlying earnings.

[00:42:45] This could definitely lead to lower return on invested capital for Constellation, as more companies try and copy what they’re trying to do. I had mentioned that Leonard measures returns based on the return on invested capital in the net organic revenue growth. If they aren’t able to increase their organic revenue growth, that will also hurt the underlying return of the business as well.

[00:43:05] From 2013 through 2020, it’s only averaged around 1.8%. So, most their growth just solely comes from their acquisitions, which of course will they’ll be highly reliant on for future growth. Since some of these businesses are transitioning from the licensing to SaaS model, we may see some headwinds in the organic revenue growth in the short term, but longer term, this will be beneficial to their growth going forward.

[00:43:30] Now, I’m not one to say whether Constellation Software will be a good or a bad investment as the future’s just unknowable and this business, there’s just so much that we don’t know about it, you know, regarding their acquisitions. But I can try and make some educated guesses. Many people tend to have high conviction either way.

[00:43:48] Either it’s impossible to continue to earn these outsized returns and reversion to the means inevitable. Or you know, a lot of people are saying Leonard is like a Warren Buffett and he’s built a company and a culture that’s just impossible to be replicated and for competition to disrupt. Until today, it seems that Leonard still has his magic touch and there’s just no slowing down this compounding machine.

[00:44:10] I ended up deciding to take a position myself in Constellation Software here in mid-February 2023. A lot of people invest in Berkshire Hathaway because they really trust Warren Buffett more than about anyone in their life. They don’t care about what business he’s buying or selling. They don’t care whether the stock is up or down.

[00:44:29] They just know that he will do right for long-term shareholders, and they know that they won’t be taken advantage of by Warren Buffett. This is the way I view Mark Leonard in Constellation Software. He’s one of the few managers I’ve found that I’d be comfortable giving a substantial portion of my wealth to if I had to.

[00:44:47] But one of the differences between Constellation Software and Berkshire Hathaway is that Constellation is achieving much higher returns on capital, and thus is vastly outperforming the market. It’s still in its earlier stages relative to Berkshire Hathaway in my mind. Over the past five years, shares of Constellation are up 25% annualized, and the price of free cash flow is around 30, which is a price I’m willing to pay for a manager in a business this high quality.

[00:45:13] As a value investor, the goal is to buy a business that you believe is undervalued relative to what you believe the business is conservatively worth. And I do recognize that while I’m saying this, the stock is trading near its all-time high, and I may look totally wrong in one or two years if the stock trades sideways or trades down for a while.

[00:45:32] But historically, this stock is a prime example of a winner that just keeps on winning in terms of both the stock price and the underlying business. To me, value doesn’t mean a stock has a low pe, a low price to book, or a high dividend yield. Like Bill Nygren once said on our show, value to me is that you’re getting more than what you’re paying for.

[00:45:53] Just running a quick DCF analysis, if the company is able to grow their free cash flows by 15% over the next decade and you assume a terminal of multiple of 25, this would imply that the stock is significantly undervalued today. But the big if is how long they’re able to grow their earnings in, continue to reinvest at a high rate of return.

[00:46:14] For years, investors have been skeptical of Constellation, yet they’ve continued to do what seems to be defying gravity. Using a more conservative valuation, if the free cash flows were to grow at 10% per year over the next decade, and we assume a 20 times terminal multiple, then the stock is treating around its fair value.

[00:46:32] So it really all comes down to how long Mark Leonard and the team can continue to reinvest at high rates of return, whether that be by expanding into larger VMS businesses, or expanding into new markets. This is a very high-quality business from my point of view, and when I find a high quality business like this that I deem to be of reasonable valuation, I don’t try and get Q waiting for the next dip.

[00:46:56] So I initiated a position and will continue to buy more throughout 2023, likely, regardless of the shares are higher or lower from where they’re at today, down the road. The final risk I see with Constellation is something happening to Mark Leonard and him no longer being a part of the business. Some believe that the business is somewhat reliant on him, but it really seems to me that he has this decentralized structure in place where he gets honest and competent managers who are able to work together and come to their own conclusions rather than relying on him or relying on upper management.

[00:47:29] Leonard has put together a brilliant system in place, and for it to get to the size, there’s really no way, it all has to be based on his ingenuity. The company IPO’ed in 2006, so there’s been plenty of time for him to put together the necessary systems in place for the overall business, but it’s definitely a risk worth mentioning in considering. This obviously is not a buy or sell recommendation.

[00:47:52] I’m not a registered financial advisor, so I can’t give financial advice. I’m just sharing what I’m doing with my own portfolio. If you aren’t one to invest in individual stocks, then please ignore what I’m doing. I just want to provide full disclosure for those who are listening, as obviously I may be biased to the upside for this company.

[00:48:10] So Constellation Software is listed on the Toronto Stock Exchange, under ticker CSU, and since I’m in the US I needed to set up a brokerage account on IBKR to purchase the shares under their ticker CSU. There is an over-the-counter ticker also, CNSWF, but it looks to me that this is very thinly traded.

[00:48:30] So I wanted to get the CSU shares on the Toronto Exchange through IBKR. That’s just a heads up for those that are interested in how I myself, got exposure to the company. Again, not a buy or sell recommendation, I’m just stating what I’m doing. Constellation delayed the release of their Q4 2022 results until March of 2023, so that hasn’t been released at the time of this recording.

[00:48:52] Looking back at their Q3 results, they’re still growing really fast. Their revenue increased by 33% year over year. Their organic net revenue growth was minus 3%, so their acquisitions really fueled this growth, as with most other years. Revenue was 1.7 billion for the quarter, and net income was 136 million, up 28% year over year.

[00:49:15] The free cash flow available to shareholders was 229 million, which I see as really good as this is much higher than their reported net income. As I mentioned earlier, Leonard believes that the gap reporting standards do an injustice to companies like Constellation because it makes it look like the company is making less money than what is actually economic reality within the business.

[00:49:37] It just doesn’t reflect economic reality, and that’s why you’ll see a company like Constellation trading at a super high pe. It’s because those earnings don’t really reflect reality, so you have to look at their true normalized earnings and make come to your own conclusion on what the business is making.

[00:49:53] For those earnings, depreciation write-offs are being considered in those calculations for their intangible assets. But if revenues and earnings of the underlying businesses are increasing, then there’s really no reason to believe that the value of those intangible assets are decreasing, and you should have to that depreciation expense.

[00:50:11] If anything, the value of those assets are actually increasing. What’s also interesting about this stock is that their strategy is counter cyclical. During recessions, capital conditions are tight, and sellers become desperate. So, companies like Constellation are able to get really good deals during these times.

[00:50:29] Larger companies may be more willing to carve out their VMS businesses during a recessionary environment as well, which makes Constellation a natural and experienced buyer of these deals. I also like how Leonard seems to run the company very conservatively. He only purchases deals that offer attractive returns for investors, and he isn’t really going to be taking much risk in using leverage and whatnot.

[00:50:53] As I mentioned, the price of free cash flow is around 30 today, and historically this is trended in the 25 to 30 range for the past five years. So today is trading around the higher end of the multiple at twenty three hundred and seventy five Canadian dollars. In Chris Mayer’s book 100 Baggers, he notes that some of the best performing stocks in compounders are going to spend a lot of their life, by definition at all time high valuations.

[00:51:18] So even though the multiple is on the higher end today, if you try and wait for it to hit a multiple of say 25, you may still be paying a much higher dollar price in the future because the earnings have outpaced the multiple compression. Surround some more quick numbers. Today’s market cap in USD terms is 37.5 billion dollars with 1.2 billion dollars in free cash flow for the trailing 12 months.

[00:51:43] If the company manages to grow their free cash flows by 20% for the next three years, and the multiple were to compress from 30 to 25, then you would still achieve an 11% annual return on investment over that three-year period. Running a little bit different scenario, I think of 15% growth rate of their free cash flows is fairly conservative for the next five years.

[00:52:06] If they grow at that rate for the next five years and the multiple compresses from 30 to 25, then I come up with an annual return of around 10%. So, you really just need to have a longer time horizon and believe that Mark Leonard’s going to continue to reinvest at high rates of return. Again, this is a quote I’ve mentioned a number of times on the past.

[00:52:25] It’s a Charlie Munger quote where he says that the returns of a company tends to trend towards the returns that the underlying business owns. So, if Constellation is able to consistently earn 20 to 30% return on invested capital, then the longer I hold the stock, the less of a role the multiple will play over time.

[00:52:44] Valuation can be a little bit tricky for a company like Constellation because making projections into the future is extremely difficult. If not, impossible. Almost any model over the past years would’ve told you that Constellation shares were expensive or too high. But Mark Leonard and the team continued to defy gravity as they continued to deploy more and more capital at very high rates of return.

[00:53:08] It’s similar to how Amazon just always looked expensive on face value, yet the stock just continued to grow, go up over the long run. So, for investors who are super cognizant of the price they’re paying, Constellation probably isn’t the stock they want to own. You know, if they have a big earnings miss or two, then you could see the stock fall substantially.

[00:53:29] Before I ever wrap up the episode, I wanted to pull one final quote from one of Mark Leonard’s letters. He says, a very special case of value investing is the example of a company that is growing quickly, that the market expects to stop growing within the next five to seven years, but that actually keeps growing quickly for much longer.

[00:53:50] If you can spot one of those, it may appear expensive on a PE basis, but may actually be an attractive long-term investment on a value investing basis. Spotting this kind of investment requires the ability to forte the distant future, which is extremely difficult to do with consistently.

[00:54:09] All right, if you think I’m wrong on Constellation or think I’m really missing something here, feel free to reach out to me on Twitter at @Clay_Finck. Tweet at me there, or shoot me a DM.

[00:54:22] I would love to hear from you, and I like to think I’m open to changing my mind when given new inform. That wraps up today’s episode. If you enjoy this episode and you know of someone that might also enjoy learning about Constellation Software, my one ask for you is to share that episode with just one person.

[00:54:41] And if you’ve really loved it, maybe share it with a few people. TIP is my full-time job, and we are just so grateful for you checking out our show. To help ensure that we can continue to provide these episodes to you, it would mean the world to me, if you took one minute out of your day and shared this episode with someone you think would find it valuable, it would truly mean the world to me.

[00:55:02] So thank you for those of you who do. Thanks for tuning in and I hope to see you again next time.

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