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  • Writer's pictureChris Mayer

100x: Almost There

“A constellation is nothing more than an arbitrary grouping of stars.”

- Carl Sagan

The story goes that Alfred Korzybski once strolled into one of his seminars munching on a bag of cookies. He offered his students some. Several took him up on the offer and soon they, too, were munching away on these cookies.

Then Korzybski tells them the “cookies” are actually dog biscuits. And the students spit them out and retched. I wouldn’t recommend a teacher try this today, but Korzybski had made his point. What we call things can have a big influence on how we think about them.

So what if I told you about a company with great returns on invested capital (ROIC), low leverage, moaty businesses, a great capital allocator at the helm, an owner-oriented culture and a history of mouth-watering returns? Interested?

Now, what if I said it was a “rollup”?

Mark Leonard & Constellation Software

I recently spent an afternoon reading all of Mark Leonard’s annual president letters. (Available here). Leonard is the founder of Constellation Software. The stock has been a giant winner since its IPO in 2006 – up more than 80x. It seems on its way to joining the 100 bagger club.

I have never read these letters before, nor have I ever spent much time looking at Constellation. This may surprise you, given how successful the stock has been and given that so many investors seem to rave about these letters. I think you may find the reasons why I never read them instructive for your own investing.

First, I can’t read everything. Nobody can. You must be mindful of your most precious resource: your time. And so you have to set up filters or you get overwhelmed. One of those for me was stay away from rollups. For years and years, I saw Constellation as a hyperactive rollup from Canada. I’ve seen plenty of those blowup, from Kingsway to Valeant. No thanks.

Further, I remember Grant’s wrote a bearish piece on Constellation, published on December 9, 2016, which further soured me on the idea. The “essential points” of the bear thesis were these:

“Competition in the software business is hotting up; competition to acquire desirable software businesses is likewise intensifying; Constellation’s disclosure falls well short of de minimis, a fact, which means that investors must trust rather than know; and Constellation may be too big to match its historic feats of expansion, though shares are priced as if it will.”

Grant’s says it is hard to know what the company actually does: The company had acquired “300-odd software businesses whose output is sold in more than 75 distinct niches.” (There are more today). Grant’s also finds fault with the disclosures, pointing out how they are internally inconsistent. The answers they get from CFO Jamal Baksh are not helpful and even seem evasive.

Grant’s finds that an investor cannot tell if the company is growing organically. For example, according to Grant’s (and as verified by Baksh in the piece), the company includes price increases of acquisitions in its organic growth figure. Not cool. There is more, but you get the gist.

So Grant’s piece confirmed my suspicions. Something’s not right with Constellation. Rollups are risky. Stay away and move on to other things…

Now, of course, I wish I dug in myself. Because, after reading Leonard’s letters, it seems impossible to imagine that I wouldn’t have become more interested.

Leonard writes his letters in a way I wish all CEOs would write their letters: from one business owner to another fellow owner. He focuses on things that matter – like ROIC – and writes thoughtfully about how to think about and evaluate the business.

Then there are passages that make Leonard seem a special character in the firmament of founder CEOs:

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

There are other bits that speak to a good, owner-centered culture:

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

And later he says of his managers:

“We also pay them well. They are all millionaires many times over, with much of their net worth invested in unescrowed CSI shares.”

These ownership attributes are hard to find in public companies and I value them highly. Their presence alone would have me interested to learn more.

Lessons from this experience? I thought of a few.

Don’t let labels do your thinking for you. Korzybski emphasized how labels influence our thinking and the importance of piercing those labels. But here I think I let the “rollup” label get in the way of taking a look. Had I dug in a bit more, I would’ve seen there was something special going on here.

Don’t be afraid to re-visit ideas. There is no reason I should’ve let a piece from 2016, no matter how persuasive, keep me off the idea for so many years. Generally speaking I do revisit ideas. I can think of stocks I rejected at first and then came back to and wound up owning. Something clicked the second time that didn’t the first. Or something changed. In any case, revisiting ideas seems a good practice.

Check it out for yourself. Everybody looks at a business and sees different things. For example, I am keen to find that ownership culture I mentioned above. I know other investors who would look past those cues because they don’t care as much. They’re focused on other things. Maybe things I care less about. Neither approach is “right” or “wrong” – we just have different ways of finding what we want. I have a short checklist that doesn’t take me long to apply on a first screening. Had I applied it to Constellation, I would’ve taken a deeper look.

None of these are new, I know. But good investing principles, like exercise, require repetition to show results. Nobody gets biceps after one set of curls, if you know what I mean.

Constellation Today

So what about the present?

I can’t help but wonder if Constellation’s best days are behind it. The company enjoys very high ROICs, which bode well for its ability to create value. However, its reinvestment opportunities may be shrinking. Acquisitions are key to its growth and the stock’s valuation.

Leonard himself walked shareholders through a remarkable exercise in the 2014 letter on valuing Constellation. He made the following striking comment:

“If we assume that CSI makes no further acquisitions, the Consensus Model calculates an intrinsic value that is roughly half of the current price. The magnitude of this valuation change surprised me, and suggests that our stock price could suffer very significantly if our acquisition activities slow down or the acquired businesses perform poorly.”

Then again, such questions have dogged the stock for some time. (See the last of Grant’s essential points – actually, all of these points still seem relevant). And yet, here is Constellation’s stock near fresh all-time highs. Recent results seem to suggest no such slowdown. And the stock is up another 20% year-to-date as I write.

I think such results would’ve surprised even Leonard. In his last letter, which covers the 2017 season, Leonard writes: “I have difficulty forecasting long-term growth in Constellation’s intrinsic value per share that exceeds 12% per annum.” (Or maybe he's just talking down the stock when it seemed rich).

In any event, I’d take 12%, especially if it is a steady, unlevered and relatively low-risk 12%.

Funny to think that in his 2010 letter, Leonard writes about how the company’s shares got so little respect in the market that Constellation undertook a strategic review. That was a long time ago from where shares are now. Back then, shares traded for ~12x earnings and you got a free cash flow yield of ~10%. Them were the days…

I’m still reading my way through Constellation’s material. I am not sure what conclusion I will come to. There is a lot to like, but there are important open questions as well. (Too bad Leonard stopped writing his letters, especially since the company hasn’t provided anything comparable to replace it.)

In any event, I recommend the letters as a case study in how a great stock unfolded over the years 2008-2018.

As an aside: I have found the best time to do due diligence on a stock is when you are not itching to buy it. That way you do the work and take your time. Then you wait for when you might get an opportunity. The market almost always gives you an opportunity. And if not, well, there are plenty of other crabs in the bay…

Thanks for reading.


Published June 2, 2020

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