Constellation Software, Letters to shareholders – Mark Leonard and his investment philosophy

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Constellation Software Shareholder Letters - Mark Leonard

Lessons in investing and business with Mark Leonard

Constellation Software (TSE:CSU) is a Canadian-based conglomerate that acquires, manages and builds vertical market software (VMS) companies. Between its IPO in 2006 and early 2020, Constellation’s share price has risen more than seventy-fold, reflecting their track record for stellar acquisition and operations. The company’s Founder & President Mark Leonard gives a short description for their success:

“[Constellation owns] robust businesses with inherently attractive economics run by good managers whose compensation is tightly aligned with that of shareholders”.

Mark Leonard

Leonard has shared a decade’s worth of lessons in business and investing in his annual letters and shareholder Q&A. What you find in them is a unique adaptation of value-investing principles, tailored for Constellation’s culture and operating model. They make for great reading, not only for Constellation’s shareholders and employees, but for students of business too.

This post will summarise the key lessons I took from Leonard’s letters. The first half will look at Leonard’s reflections on company performance, return on capital, value creation and investment selection. The second half will focus more so on Constellation’s investment, business and managerial philosophy.

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Measuring the true value of companies

One thing that may strike readers about Mark Leonard is the attention he gives to discussing performance metrics with shareholders. In particular, he pays special attention to net revenues, maintenance revenues, adjusted net income, returns on invested capital, organic net revenue and free cash flow per share. Let’s look briefly at his rationale for each of them. Keep in mind though that Constellation Software invests in software businesses. These metrics might be less relevant to capital intensive businesses in other industries.

Net and maintenance revenue

Net revenue is GAAP revenue less third party expenses and flow-through expenses. Leonard likes the metric’s focus on ‘value-added’ revenue, which is sometimes lower for commodity hardware or third-party software. Constellation also focuses on net maintenance revenue. This is maintenance revenue less third party maintenance costs. Leonard believes that net maintenance revenue is an important indicator of intrinsic value for software companies. The operating profitability of low growth software companies should move closely with net maintenance revenues over time.

Adjusted net income and return on capital

Constellation looks at adjusted net income, which, by their definition, is cash profits after cash taxes. It’s one measure of economic value (assuming that the company’s intangible assets is not deteriorating). Leonard also thinks about capital that shareholders have invested in the business. Here, Constellation uses a return on invested capital (ROIC) that is more akin to a cash-adjusted return on equity. It’s important to note that financial leverage can affect this metric.

From an investment standpoint, real value depends on the cash purchase price relative to the future cash produced and returned. GAAP accounting and metrics like EBITDA, in Leonard’s view, may not always reflect economic reality. And while cash flows after tax, interest and CAPEX are useful for assessing the real return on shareholders capital, it makes an implicit assumption about the health of the company’s assets.

For software businesses, Leonard believes that growth in maintenance revenues should provide some evidence that the business’ intangible assets have not deteriorated. He also thinks about the internal rate of return of acquisitions and R&D projects, and the attrition rate of assets (i.e. lost customers or modules). Companies with low profitability and high attrition rates will require greater investment in new client acquisitions to maintain revenues.

The broader lesson here is to understand the economics of a business and its implications for profitablity, return on capital, reinvestment needs and potential growth (we wrote a little more about this here).

ROIC plus organic growth

In his earlier letters, Leonard’s favourite metric for measuring corporate performance was the sum of ROIC and organic net revenue (ROIC + OGr). He believes it is a useful proxy for the intrinsic value of companies like Constellation, assuming that that the company will continue to invest free cash flows in acquisitions of similar economic characteristics. Of course, ROIC is not always mean reverting. Very few companies are able to expand their scale and economic moats without significant cost.

Limitations of ROIC

ROIC + OGr may mislead investors if companies: (1) pay high multiples for acquisitions, (2) use a lot of debt for purchases, and (3) buy back shares and pay dividends in large volumes (remember that Leonard’s definition of ROIC is closer to ROE).

Similarly, companies that grow revenues or earnings at the impairment of intangible assets are not generating a return on capital but a return of capital. We should expect ROIC + OGr to converge towards our hurdle rate if all free cash flows are redeployed, and our IRR accurately forecasted.

For well-managed asset-lite businesses, ROIC might reach very high levels if the company achieves much of its growth organically. For this reason, Constellation likes to track the IRR of acquisitions and projects; and report revenue and cash flows from operating activities on a per share basis. Although these measures doesn’t unpack performance in the context of debt levels and/or reinvestment needs.

Increasingly high ROIC might also distort ROIC-driven compensation schemes. Here, Leonard considered two solutions: (1) change the compensation plan and/or (2) cap bonuses. While the former erodes employee trust, the latter generates incentives to reallocate profits between bad and good years. Instead, Leonard likes high ROIC businesses to redeploy capital into new opportunities in an attempt to generate similarly high returns on capital. Here, managers are rewarded further for generating high profits and/or growth.

Free cash flow growth per share

In his 2018 letter, Leonard began to reflect on better measures for assessing company returns. While he liked return on incremental capital invested, he was wary of its volatility and sensitivity to non-operating activities such as share repurchases and issuances. Similarly, while net maintenance revenue per share is helpful, it is also sensitive to abuse because we cannot derive it from audited financial statements.

Furthermore, when bonuses depend on financial performance, there is incentive for managers to recognise revenue early or aggressively. This is particularly so during tough economic conditions. In his 2008 letter, Leonard observed that aggressive recognition is often reflected in accounts receivable and work in process; and that measures like tangible net assets to net revenue may hint at such behaviours. (For those interested in this topic, we strongly recommend Howard Schilit’s Financial Shenanigans: How to Detect Accounting Gimmicks).

For the reasons above, Leonard landed on free cash flow growth per share as his preferred measure. It takes dilution, interest expenses and capital expenditures into account, but doesn’t adjust for minority interest liabilities. Constellation’s CFO preferred adjusted net income per share instead since it’s less sensitive to swings in net working capital, and adjusts for minority shareholder claims. Once again, Leonard reminds readers not to rely on a single metric to assess company performance. The “enterprising long-term investors will look at many metrics”.

Value creation and investment selection

Growing revenues while maintaining short-term profitability is a major challenge for software businesses. This is particularly tough because investment cycles in some segments can take more than a decade to generate returns.

Leonard outlines several properties common to high ROIC-generating software companies in his 2015 letter to shareholders. It provides a simple but helpful template when thinking about competitive advantages and value creation. These factors include: (1) customer captivity; (2) superior coverage; (3) defensible niches; (4) calm waters; (5) founder’s haven; and (6) value plays. They share similarities with Professor Bruce Greenwald’s Competition Demystified, which focused on the barriers to entry that contribute to enduring value creation. We summarise them, briefly as follows:

Customer captivity

Here, the company might achieve high market share in core segments through organic growth and/or acquisitions first. Then the company might build or purchase more add-ons to better serve their customers. This would allow the company to raise prices, switching costs and its return on invested capital. Companies like Facebook have very strong customer captivity due to unparalleled network effects. Others, like Bluehost, rely on their core service (e.g., web hosting) and sales of add-on services (e.g., plugins, security, etc.) to generate additional revenue.

Superior coverage

Alternatively, some companies might build or acquire several business groups that operate independently within the same market. While this might duplicate costs, the focus on product differentiation and customer coverage may enable greater market share. However, business units may find investing in add-ons trickier. This is because each business unit that operates autonomously at smaller scales may find it difficult to justify each investment project individually.

Defensible niches

Where companies are not a dominant market leader or able to grow via acquisitions, they may focus on creating a defensible, differentiated niche. If industry attrition rates are low, such strategies might still offer profitable growth via expansions in service, support and add-on products for existing customers.

Calm waters

Leonard likes businesses that can grow at a faster rate than competitors, and at a higher return on capital. This edge allows them to reinvest in customer captivity and organic growth. ‘Slightly’ is the important adverb here. Incremental gains in market share are less likely to elicit “scorched earth competitive” responses that brings pricing, research & develoment, and sales & marketing to unsustainable levels.

Founders’ haven

If growing via acquisitions, Leonard prefers to purchase founder-owned businesses. Because founders are relatively more long-term oriented, this tends to have positive effects on employee selection, organisational development and corporate culture. In turn, these advantages are likely to translate into better customer relationships, product development and continuous improvement.

Value plays

Finally, Constellation likes to make the occasional value play in high quality but temporarily distressed assets. This tends to occur in periods of recession, previously mismanaged spinoffs and private equity divestitures. However, relative to founder-based acquisitions, value plays may impose greater culture challenges for the acquirer.

Constellation has also taken minority interests in publicly listed software companies on occasions. While these interests are made with “value” in mind, Leonard believes they can carry higher incremental risk because outsiders do not have full access to information that pertain to long term decisions and trade-offs that these companies will make.

A thought experiment on growth

In his 2015 letter, Mark Leonard asks readers to compare two businesses that earn very high and identical after-tax internal rate of returns. The first is a high-profit declining business, while the second is a low-profit growing business. He asks readers which business they would prefer to invest in. His answer: Invest in both, particularly if opportunities are scarce. Constellation cares about the IRR, not whether it comes via high or low growth.

Organic v acquisitive

Since Constellation’s IPO, Leonard has always been careful to distinguish between two sources of growth: (1) acquisitions and (2) organic. Organic growth can come from price increases and new maintenance revenue. But attrition via lost modules and customers may detract from it. Strong maintenance revenues and low attrition rates are positive signs of strong customer loyalty and high switching costs.

The growth bias

Leonard suggests that balancing the trade-off between profitability and organic growth is one of the toughest challenges for managers in software businesses. Great managers have to maintain profitability during difficult times without compromising long-term research & development.

Initiatives and sustenance

For the reasons above, Constellation separates R&D, and sales and marketing expenses (RDSM) into ‘initiatives’ and ‘sustaining’ categories. ‘Initiatives’ focused on long-term organic growth-generating investments with a five to ten-year payback period. This distinction is important because it allows Constellations to understand and monitor each initiative’s internal rate of return. Not many companies take such a rational and data-driven approach to long-term investment decision making.

MECE modelling

Constellation uses a mutually exclusive collectively exhaustive (MECE) approach to assess investment opportunities. They assign probability weights to cash flows under different scenarios. They then apply a hurdle rate to compare different investment prospects with different risk profiles. Leonard notes the use of similar hurdle rates for all opportunities, from acquisitions to internal initiatives.

The Constellation styled investor

Readers of Mark Leonard’s letters will identify several themes that resonate strongly with the company’s CEO. This includes setting high hurdle rates, looking for a margin of safety, and taking care with leverage and the complexities that come with growth. He also emphasises the importance of customer, employee and shareholder alignment to long-term value creation.

High hurdle rates

To select investments that generate a high return on capital, investing with high selection standards, strict discipline and a margin of safety is important. As Leonard observed in his 2016 letter, lower hurdle rates at Constellation were correlated with lower resulting IRR. This was true not only for projects selected at the margin, but for all projects in general. There’s a sort of magnetism between low standards and poor performance.

Leonard provides some advice on this front. Firstly, it’s helpful to keep early burn rates low as we test our investment thesis. We should move on when it’s clear that the project cannot meet our strict hurdle rate. And if we cannot find alternatives that meet our hurdle rate, we should be happy with holding cash.

Constellation’s founder also highlights that there is value in training managers to become effective capital allocators as the company scales. This was particularly important at Constellation given their trust-based culture, long-investment horizon and large volumes of small business units.

Value and momentum

When asked about the reasonableness of high multiples in today’s markets, Leonard suggested it helpful to distinguish between value and momentum. While the latter is a workable strategy, it depends more on emotion than logic, which Leonard prefers to stay away from.

However, sometimes the market will price in multiple years of growth when the company has even greater opportunities to scale. While these companies might look expensive, they might still be trading below their intrinsic value. The challenge for investors is in spotting these opportunities.

Margin of safety

Leonard reminds readers that great companies do not always make great investments. High multiples and market manias can eliminate the margin of safety in the best of companies. Leonard suggests it’s time to worry when companies begin trading at prices at 5 to 6 times revenue per share.

Care with leverage

Leonard has a few warnings about leverage. While some debt facilities are attractive when cheap and ‘long-term’ on paper, their complex covenants can lead to technical defaults at the very worst of times. Leonard wouldn’t oppose financing with debt if they were truly long-term and non-callable, with options to defer interest payments temporarily.

While Constellation is averse to leverage, Leonard is not strictly opposed to it. He describes how acquirers and buyers are scarce when economies slow, credit dries, and capital flees. During such occasions, a change in capital structure to pursue more rapid growth may create long-term value. This was the case for Constellation during the GFC when many previously expensive businesses had now become affordable.

In his 2013 letter, Leonard had also considered freezing dividend payments to finance acquisitions during the GFC. However, he did not like the idea of disenfranchising existing shareholders who had purchased shares on the expectation of continued yield. In this regard, we found Leonard’s philosophy on dividends and buybacks (which we’ll discuss later) to be quite different to other capital allocators. (Although Leonard has since reversed his position on this topic in his 2021 letter, with Constellation scaling back special dividends in favour of reinvestment)

Managing complexity

Constellation’s biggest worry in the early 2010s was managing the complexity that comes with continued growth. Jeff Bezos expressed a similar concerns in his letters to shareholders with Amazon. Leonard suggests that it is important for managers to reflect on their capacity to manage their business units through growth.

Interestingly, Constellation has considered the trade-offs between a ‘large and concentrated’ strategy and their ‘many verticals’ strategy. In Leonard’s view, while the latter is more complex from a management standpoint, the former may require more isoalted acquisitions at higher multiples and lower ROIC.

As such, Leonard prefers to operate with smaller business units and leaner central head offices. This is reminiscent of Warren Buffet’s Owner’s Manual for Berkshire Hathaway. To Leonard, the trade-off between agility, innovativeness and scale is not a general rule. From an analysis of their own portfolio and business units, Constellation did not observe a correlation between business unit size, growth and profitability.

Correct contrarians

“You can’t be normal and expect abnormal results.”

Jeffrey Pfeffer

Leonard reminds his readers about ‘correct contrarians’, an important tenet in value investing. That is, investors with unpopular but well-founded beliefs are more likely to outperform the market over time. Inversely, investors that hold only the consensus view are unlikely to outperform at all. According to Leonard, knowing how to separate signals from noise and when to be contrarian requires deep focus and a circle of competence.

Listening to Wall Street’s noise

“Science is organised scepticism.”

Robert K. Merton

However, this is not a recommendation to be contrarian for the sake of contrarianism. In a 2018 Q&A, Leonard noted that he doesn’t ignore Wall Street, the media and investment analysts. In many cases, they are focusing on the right opportunities and information sets. He only ignores them when he believes they are wrong.

Fostering organised scepticism

“Too much of business is disorganised optimism.”

Poster in Constellation’s board room.

Similarly, Leonard recommends we surround ourselves with logical, intelligent and curious people with a culture of experimentation and deliberation. It can help us to see facts and reason that others have missed; and is a safeguard against a unhelpful biases and heuristics, like unconscious or confirmation bias. The issue, Leonard says, is that investors are too focused on trading stock certificates. This generates a zero-sum game that creates little value for society (beyond price discovery).

Making decisions under uncertainty

In his 2017 letter, Leonard points out that we may not always have the necessary data to make informed decisions. In these situations, we have to act on logical beliefs and qualitative factors until more evidence is available to shape our thinking. Validating hypotheses in business is difficult given the limited number of controlled trials with large sample sizes on the market. The reality is that decision making rests mightily on our beliefs. We can tilt the probabilities in our favour if we invest with discipline and a margin of safety. (For the interested, Berkshire Hathaway’s Charlie Munger has shared similar ideas in his speeches about the Art of Stock Picking and The Psychology of Human Misjudgement.)

Learning from our mistakes

“There are three kinds of men. The ones that learn by reading’. The few who learn by observation. The rest of them have to pee on the electric fence for themselves.”

Will Rogers

Leonard reflects on Constellation’s biggest mistakes in a 2018 Q&A. First, he mentions the mistake of raising too much capital when Constellation did not need it. It resulted in significant dilution for existing employee shareholders. The second was selling one of Constellation’s verticals shortly after an acquisition. While they liked the company’s economics and team, Constellation was early in its history, less confident in their ability and opted for the quick win. This sale detracted from their philosophy and reputation for long-term orientation.

Alignment at Constellation

Another striking feature of Mark Leonard’s writing is the emphasis he puts on protecting the interests of Constellation’s employees, customers and long-term shareholders. He believes that shared alignment between all stakeholders is critical to long-term success. This is evident in the way he thinks about employee compensation, mergers & acquisitions, share buybacks, the company’s stock price and board governance.

Alignment creates value

One of the owner’s task is to find, incentivise and nurture energetic, intelligent and ethical general managers to generate shareholder value over the long-term. Leonard espoused a culture of trust among managers and employees. He incentivised them with shares (escrowed for 3-5 years) to improve their economic alignment with shareholders.

When introducing new compensation schemes, Leonard makes it optional for employees to opt-in. This is to preserve employee trust. Leonard suggests that if employees believe their compensation is fair, then retention becomes a function of the company’s capacity to offer meaningful work, autonomy, professional development, work-life-balance and other typical factors that employees expect in their careers.

Leonard wants employees to prioritise long-term profits over short-term bonuses. For this reason, Constellation prefers to promote from within because trust and loyalty takes many years to develop.

M&A can erode trust

Leonard reflected on the adverse consequences of M&A in his 2010 letter, when Constellation’s board considered selling Constellation itself. Firstly, the M&A process creates large distractions for the company. It’s a substantial opportunity cost for employees involved. Secondly, the process can hurt long-term relationships with important stakeholders. It can generate worry, distrust, uncertainty and short-termism amongst employees, customers, suppliers and shareholders. In my opinion, the impact of M&A on employee morale, productivity and culture does not always receive sufficient attention.

Buybacks transfer value

In his 2013 letter, Leonard discussed the temptation of share buybacks. While Wall Street might view buybacks favourably, he believes buybacks are sometimes inappropriate. He describes how it can transfer value from outside owners to inside owners if purchases are made on the basis of inside information. Leonard highlights his obligation to protecting long-term oriented non-professional shareholders and employee shareholders by ensuring the stock price is within fair value range.

Upholding fair value

Leonard has expressed his preference to discuss matters pertaining to Constellation as the business and not the stock. He originally believed that if owners and managers focused on company fundamentals, the stock price would reflect underlying value sooner or later.

However, his experience with Constellation’s potential buyout in 2010 made him revise his position. If the stock price remains well below intrinsic value for too long, you may attract ‘barbarians at the gate’. By contrast, if prices remains well above intrinsic value, you may lose loyal and long-term oriented shareholders and employees who prefer to sell out.

For these reasons, Leonard began to take a more active role in ensuring Constellation’s stock price was within a reasonable range of intrinsic value.

Directorships at Constellation

“We should no more trust executives who rely solely on experience than we should trust doctors who ignore clinical trials.”

Simon London, Financial Times, Jan. 2006.

In his 2018 letter, Leonard outlines the criterion he looks for in new board directors at Constellation. We believe his notes are quite reflective of Constellation’s ingredients for success, and worth noting in brief.

Firstly, Constellation seeks directors that will operate as long-term oriented thought partners for senior leadership. They must be willing to serve for 20 years or more. Secondly, they want directors that share their belief in shareholder alignment and are willing to take large equity stakes in the company. Thirdly, they must understand the drivers of high-quality businesses, and the benefits of business unit autonomy and decentralisation. Fourthly, they need to coach and nurture company talent as well.

Furthermore, directors must exhibit a high impact but low ego personality. They will contribute meaningfully and intervene when needed. But they’re careful as to not dominate discussions or disrupt the autonomy of their managers. These directors should also be experienced capital allocators with a penchant for generating consistently high ROIC. Unsurprisingly, Leonard is also biased towards CEOs with great shareholder letters.

Competent board directors are rare. Many have terrible track records. For this reason, Leonard advises against term limits. By doing so, we limit their opportunities to learn and add value. It isn’t easy to find or replace effective directors.

From Kahneman to Cochrane

Finally, Leonard has several book recommendations. They provide another layer into his philosophy.

In 2013, he suggested Daniel Kahneman’s Thinking, Fast and Slow, which helped him to appreciate the efficiency and dangers of intuitive judgement. He also recommended Robert Axelrod’s The Evolution of Cooperation. The book discusses competition and cooperation in a Prisoner’s Dilemma environment, a helpful mental model for many business problems.

Leonard also recommended A.L. Cochrane’s One Man’s Medicine: An Autobiography of Professor Cochrane, and Effectiveness and Efficiency, Random Reflections on Health Services. He found Cochrane’s reflections in epidemiology to share many parallels with the business world.

Constellation also likes to select a company that has achieved long-term outperformance for detailed study every quarter. One of Leonard’s favourite is Jack Henry and Associates (JKHY), recommending the book “You Don’t Know Jack… or Jerry” to learn about their history.

References

If any of the commentary here resonated with you, do take the time to read or re-read Leonard’s letters in full. It’s difficult to capture his ideas and clarity in a short format post like this.

Further reading