Constellation Software – Takeaways From Mark Leonard’s Shareholder Letters
This article contains a brief description of Constellation Software, some thoughts on its competitive advantages and excerpts from Mark Leonard’s excellent shareholder letters. The excerpts are quite long, about 5 000 words, and I recommend going to the source to read all letters. This article has only small samples of Leonard’s wisdom. The article is not an analysis of Mark Leonard nor Constellation Software, but the excerpts from the shareholder letters give you insights into a great business mind.
The letters offer great insights into a very successful company, and investors can learn a great deal from studying Constellation’s history and capital allocations. Under Mark Leonard’s leadership, Constellation Software has had strong revenue growth without impairing profitability. Mr. Leonard and Constellation Software have been a serial acquirer of software businesses, mainly VMS companies (vendor management system), and turned them into decentralized business units. The result has been a spectacular 43% annual growth in the share price. Constellation has managed an average 31% return on invested capital (ROIC), according to Morningstar, which is pretty exceptional. The ROIC shows just as good returns now as ten years ago.
Table of Contents
Mark Leonard:
Mark Leonard, an Englishman and former venture investor, founded Constellation Software in 1995. It went public on Toronto Stock Exchange in 2006 and the share priced has witnessed a spectacular 43% CAGR since then.
Constellation is a vertically integrated software company where the main growth comes from small acquisitions. The focus is niches which are too small for big players to care about and where the software is a critical part of the business. This is for example customized software to a cab-driver company, a school or a hospital (most of the revenue comes from the public sector). The software is “sticky”. Maintenance revenue accounts for about 60% of annual revenue, and this is of course recurring revenue.
Hundreds of companies in the 5-50 million range have been acquired since 1995, but going forward we can expect bigger deals. Constellation is a “perpetual” owner and aims to own the subsidiaries for a very long time. The businesses are run independently from each other, and managers recruited 100% internally, have incentives that are aligned with outside investors, discussed at length in his letters.
I believe the moat comes from the culture and the way Constellation is managed:
- An extremely decentralized structure.
- Software is inherently sticky (recurring revenue).
- Niche businesses that often aim for the public sector (solid clients – less risk for bankruptcy).
- Vertically integrated and diversified in terms of products, suppliers and customers.
- Great leadership in Mark Leonard.
- Owner-operated, Leonard owns almost 1.5 million shares. No stock options – all managers are required to buy stocks in the open market with their compensation.
- Rational capital allocation.
- Capital for acquisitions comes mainly from free cash flow (very little leverage).
Furthermore, I believe Constellation is in a good business where the runway is still long: Leonard writes they have a database of 10 000 companies.
Warren Buffet light?
My personal preference is to invest in owner-operated companies. In this case, I believe Leonard is an exceptional CEO: He has no salary, no performance compensation, a great shareholder letter where investors easily get to understand the business, and a strong focus on decentralization to avoid red tape. He leads by example. Both the conference calls and shareholder letters resemble in many ways Warren Buffett. They are both great at explaining their thinking and focus on what is essential. There is no FOG (ie. use of glossy words without meaning and context).
Negatives:
The earnings multiple, at almost 50, is elevated and need to see continued strong growth to be justified. As Constellation grows bigger, management either needs to do more acquisitions or make bigger ones.
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Now let’s get on to the excerpts from the letters. I would like to emphasize that some of the excerpts might not be that interesting, but I have included them so the reader get a better grasp of the history and development of the company.
2008 letter:
I am often asked why Constellation takes minority interests in other public software companies. The answer is simple (value!), but it can be complicated by our investment horizon and by our requirement that the company have competent ownership.
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It is trivial for an experienced GM (general manager) to run a software company to generate high profitability and shrinking revenues. Far more challenging, is generating reasonable short term profits while continuing to grow revenues, in an industry where investment cycles often exceed 10 years. Understanding a GM’s performance as they make these long term trade-offs is the most difficult part of a perpetual owner’s job.
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We have bought more than 70 private software businesses outright. On ten occasions, however, we have also participated in the purchase of significant minority positions in public software businesses. Usually these minority interests were purchased for less than their intrinsic value, and for far less per share than we would have had to pay for the entire business. While these purchases tend to be at the “value” end of our investment spectrum, they often carry incremental risk because we lack access to information concerning the long term trade-offs that the businesses are making. Even excellent managers of public companies are initially uncomfortable allowing us to join their boards to get access to this information, suspecting us of dire motives or a short-term orientation. We have the same objective when we buy a piece of a business as when we buy 100%, i.e. we want to be a great perpetual owner of an inherently attractive asset. If we are allowed to join a public company’s board, we offer to sign an agreement that will limit our ability to make an unsolicited take-over bid.
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When boards reject our request for representation, we may resort to “shareholder democracy”, i.e. we may approach other shareholders to request that they support our quest for a board seat. Only as a last resort will we make an unsolicited bid for a company.
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Until recently, we had avoided using significant amounts of debt. Circumstances, however, may dictate a change in our capital structure……., and for some of the same reasons, quite a number of vertical market software businesses are for sale at attractive prices. We may not be the successful bidders for these assets, but if we are, we will almost certainly be increasing Constellation’s financial leverage.
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Rapid acquired growth is not an imperative, it is a choice. For most of the last decade we struggled to find enough attractive acquisitions to consume our operating cash flows. We believe that the situation has now reversed, and we are sorely tempted to buy as many attractive vertical market software businesses as and while we can.
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You can’t judge the quality of this quarter’s acquisitions by this quarter’s profit, but after 85 acquisitions over a 13 year period, we seem to have developed a knack for acquiring fundamentally sound businesses at fair prices.
2009 letter:
We’ve handled our geometric growth to date by largely abdicating management to the general managers of each of our vertical businesses. We have a very thin overlay of infrastructure at CSI. We count on the fact that with each new acquisition will come general managers who are steeped in their verticals……veterans who have built industry leading (albeit small) vertical market software businesses with great economics. 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 in how to grow their businesses and make them even better. As long as we compensate these managers appropriately, and are not tempted to meddle too much, then I think we can scale up Constellation for many years to come.
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Only one eleventh of our shares changed hands in 2009 (vs one sixteenth in 2008). Our share price has outperformed the S&P TSX index by an average of 16% per annum since our IPO in 2006. We seem to have attracted a group of shareholders who have willingly sacrificed liquidity in return for the opportunity to make a long term investment in what they believe is a good company. We continue to seek long-term oriented shareholders that share our approach to investing.
2010 letter:
On April 4th, Constellation’s board announced that it was undertaking a review of the strategic alternatives for the company, with the objective of enhancing shareholder value. In your shoes, I’d interpret that as meaning that the company is likely to be sold.
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The marketing of the company to prospective buyers has, and will be, a considerable distraction to the managers and employees of the company. We can’t be sure that it will result in an acceptable offer. We hope to get through this process as quickly as possible, generate some liquidity for our major shareholders, and then get back to building our business.
2011 letter:
As a rule, I prefer to use these letters to write about our business, not our stock. And while I’ll start off focusing on the business, I think it is worth devoting some ink to what I think I’ve learned about managing our stock.
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I used to maintain that if we concentrated on fundamentals, then our stock price would take care of itself. The events of the last year have forced me to re-think that contention. I’m coming around to the belief that if our stock price strays too far (either high or 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.
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A long-term orientation requires a high degree of mutual trust between the company and all of its constituents.
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We trust our managers and employees and hence try to encumber them with as little bureaucracy as possible. We encourage our managers to launch initiatives, which in our industry, often require 5 to 10 years to generate payback. We are comfortable providing them with capital to purchase businesses that won’t be immediately accretive, but that have the potential to be long-term franchises for CSI. We nearly always promote from within because mutual trust and loyalty take years to build, and conversely, newly hired smart and/or manipulative mercenaries can take years to identify and root out.
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A respected investor told me, “You end up with the shareholders you deserve”. I’m hoping that’s true.
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I’ve always tried to avoid having CSI’s shares trade at too high a price. Many members of the board were conscious of the opposite problem. I think we all now acknowledge the importance of managing our stock into a price range where we neither invite another Process, nor encourage our employee shareholders and long-term investors to liquidate their holdings. I don’t think it will be difficult to keep our stock price marching in lock-step with the intrinsic value of our company. The board and I just have to be conscious of doing so.
2012 letter:
Having had the chance to review the tables, we hope you’ll join us in thanking the CSI employees for a wonderful decade. It is a rare company that consistently increases its per share financial fundamentals at such high rates over such an extended period.
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My back of the envelope math says shareholders accorded us a better than a 25 times multiple on the 2012 incremental earnings. Those sorts of market multiples create a growth imperative… you have to either rapidly grow into your multiple or disappoint your shareholders, analysts and board. So ultimately, it seems to me that it is our stock price that has catalysed the spate of questions about our “ability to scale”, rather than our practices and performance. Irrespective of the questions’ genesis, some context for what we do to generate growth seems appropriate.
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As you’d expect for venture-style investments, our initial expectations for these Initiatives were very high. We tracked their progress every quarter, and pretty much every quarter the forecast IRR’s eroded. Even the best Initiatives took more time and more investment than anticipated.
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We believe that CSI is one of the few software companies that takes a somewhat rational approach to long term RDSM investments. We didn’t get to that point with central edicts or grand plans. We just had a hunch that our internal ventures could be better managed, and started measuring them. The people involved in the Initiatives generated the data, and with measurement came adjustment and adaptation. It took 6 years, but we have fundamentally changed the mental models of a generation of our managers and employees (though perhaps not of all the steely eyed visionaries).
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Our favourite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites. Founder businesses tend to be a very good cultural fit with CSI, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the CSI umbrella.
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I believe that these business units are small for a reason…that the advantages of being agile and tight far outweigh economies of scale. I’m not a proponent of handling our “complexity problem” by creating a bunch of 400 employee business units to replace our 40 employee units. I’m looking for ways of “achieving scale” elsewhere.
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Another obvious fix for our cash constraints would be to axe the dividend. The dividend was a tactic, not a strategic move. It broadened the appeal of our stock and thereby helped us find an exit for our private equity investors. We appreciate the confidence in CSI that many of the new investors expressed in buying the PE shares. We recognise that these investors bought, in part, because of the dividend and the implicit promise of continued yield. Eliminating it would disenfranchise a group of shareholders to whom we owe our independence. That wouldn’t sit right with me and many of the senior management team, so I don’t see it happening.
2013 letter:
Ideally, we’d like CSI’s stock price to appreciate in tandem with our fundamental economics. At any point in time, we’d prefer the price to be high enough to discourage a takeover bid and low enough so that our sophisticated long term oriented investors are not tempted to sell. It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell. If a stock is over-priced and sophisticated investors sell, they are generally replaced by unsophisticated investors who are ultimately disappointed. This may lead to a stock price that over-corrects and in turn precipitate either a takeover bid, or more insidiously, a significant and predatory share buyback. Buybacks are tempting to management and boards: they tend to improve the lot of managers and insiders, while being applauded by the business press. I think they are frequently a tolerated but inappropriate instance of buying based upon insider information. Instead of shareholders being partners, they become prey.
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Varying the organic growth assumption has a tremendous impact on the intrinsic value of a CSI share. Add in another 2.5% organic growth to the base line assumption and you get more than double the intrinsic value. Subtract 2.5% from the base line organic growth assumption and you lose almost half the intrinsic value of the stock. You can see why so many software company CEO’s are growth junkies.
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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. In the early days of CSI, I assumed that shareholders would be somewhat ambivalent between receiving all of CSI’s free cash flow as a dividend, and having us invest a portion of it in acquisitions. According to the model, that is resoundingly not the case.
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The biggest surprise for me in the modelling exercise was that our multiple expansion over the last two years can be justified by our “acquisition engine”. I’d rather the market was paying for our acquisition capabilities in retrospect rather than in prospect. Nevertheless, it is clear that acquisitions have added tremendous shareholder value over the years, particularly during times of economic crisis and/or recession.
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And while we got past a few hurdles, we inevitably came up against the institutional imperative: no matter how logical and appealing an instrument may be, if it is novel and works, the sponsor gets a pat on the back. If it is novel and doesn’t work, the sponsor loses their job.
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2014 letter:
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. 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. 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. I’m getting older and wealthier and find that I’m willing to trade more of my own cash for comfort, convenience, and speed … so I’m afraid you’ll mostly see me in the front of the plane from hereon 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…….One of the results of this compensation change is that I get to side-step the agent-principal problem. My compensation for being president is now tied solely to my current ownership of CSI shares. In essence, I’m your partner in CSI, not your employee. I like the feel of the partner relationship a whole lot better.
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I find that some of our shareholders confuse CSI’s strategy with that of our business units. While there are terrific moats around our individual business units, the barrier to starting a“conglomerate of vertical market software businesses” is pretty much a cheque book and a telephone. Nevertheless, CSI does have a compelling asset that is difficult to both replicate and maintain: We have 199 separately tracked business units and an open, collegial, and analytical culture. This provides us with a large group of businesses on which to test hypotheses, a ready source of ideas to test, and a receptive audience who can benefit from their application. More quickly and cheaply than any company that I know, we can figure out if a new business process works. This sort of ad hoc experimentation doesn’t require enormous systems or the peddling of a new dogma to the unreceptive. It requires curious managers at a few dozen business units and a couple of clever analysts to plausibly test if a process works. Once a new best practice starts working within CSI, wide access to benchmarking information tends to rapidly breed emulation.We’ve found a few other examples of high performance conglomerates built around the idea of continuously refining their business processes and then driving ever more acquired businesses up their business process learning curve as quickly as possible.
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In Chart 1, you’ll see that our head office expense as a percent of Net Revenues has halved from 1.9% in 2005 to 0.9% in 2014 while ROIC has increased from 17% to 37%. Clearly trust trumped central bureaucracy in our case.
2015 letter:
If you hold investments forever, you can afford to spend a surprising amount of money to deploy capital at attractive returns.
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Only one other HPC has followed a strategy of buying hundreds of small businesses and managing them autonomously. They eventually caved in to increased centralisation. My hunch is that it takes an unusually trusting culture and a long investment horizon to support a multitude of small businesses and their entrepreneurial leaders. If trust falters the BU’s can be choked by bureaucracy. If short term results are paramount, the siren song of consolidation synergies is powerful. We continue to believe that autonomy and responsibility attract and motivate the best managers and employees.
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How about a thought experiment? Assume attractive return opportunities are scarce and that you are an excellent forecaster. For the same price you can purchase a high profit declining revenue business or a lower profit growing business, both of which you forecast to generate the same attractive after tax IRR. Which would you rather buy? It’s easy to go down the pro and con rabbit hole of the false dichotomy. The answer we’ve settled on (though the debate still rages), is that you make both kinds of investments. The scarcity of attractive return opportunities trumps all other criteria. We care about IRR, irrespective of whether it is associated with high or low organic growth.
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During that twenty year period we made three changes to the hurdle rate, one up, two down. The weighted average expected IRR for each vintage (e.g. all of the acquisitions done in 2004) of acquisitions tended to drop or increase to the newly implemented hurdle rate. Said another way, when we dropped our hurdle rate, it dragged down the expected IRR’s for all the opportunities that we subsequently pursued, not just those at the margin. We try to capture this idea by saying “hurdle rates are magnetic”. It now takes a very brave soul to propose a hurdle rate drop at CSI.
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We dislike changing bonus plans because it literally takes years for trust to re-build to the point where managers are willing to trade off short term profitability and bonus for higher longer term profitability. We saw this in spades when our major investors put CSI up for sale in 2011. ROIC increased sharply, acquisitions slowed dramatically, and Initiative spending dropped. Faced with the prospect of new owners intent on changing the bonus program and borrowing mountains of debt to acquire the business, our managers reacted as you’d expect, maximising short term profitability and bonuses at the cost of longer term growth and profitability.
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One of the concerns with acquisitive companies is that some of them grow revenues and adjusted earnings but impair the underlying value of their intangible assets. In essence what purports to be a return on capital is really a return of capital.
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The general mania which gripped the market in 2000, and the more specific enthusiasm for JKHY’s stock which then traded at well over 60 times ANI, left shareholders incredibly vulnerable. When the market “corrected” the JKHY stock had no margin of safety. When really good companies start trading at 5 and 6 times revenues, it’s time to start worrying. I hope our shareholders are never in that position.
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2016 letter:
Maintaining Investment Discipline:
In the last couple of years, a number of journalists and analysts have hinted that the Constellation Software Inc. (“CSI”) historical performance is too good to be true. They frequently conclude, in the best case, that our performance will revert to the mean. Reversion towards the mean is consistent with what we found for all the HPC’s, so I don’t disagree with their observation. Our goal, however, is to have our return on Total Capital revert to the mean as slowly as possible, while still deploying most of the Free Cash Flow (“FCF”) that we generate.
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A number of these new competitors are trolling our employee base for talent.
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I recently worked on a large transaction. With every day that passed, I could feel my commitment to the process growing… not because the news was getting better, just because I was spending more time on the prospect. The investment didn’t quite meet our hurdle rate. We were notable to negotiate a structure that got us an extra couple of points of IRR, and the big one got away.
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It also reaffirmed for me that when we pursue a very large acquisition, the diligence, structuring, negotiating and integration needs to be led by a single person who is one of our highly-experienced acquirers, and who will shoulder responsibility for the process and the outcome.
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If a small investment with a borderline hurdle rate is proposed, we sometimes allow it to proceed. Our rationale is that if the investment goes sideways, then it becomes a “lesson” for the Operating Group or BU personnel that proposed it. If the investment goes well, it becomes a “lesson”for Bernie and me.
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An investment only becomes a lesson if we diligently track its post-acquisition performance and take the time to analyse the outcome while the investment is still fresh in everyone’s mind. We have a process for this that we call a post-acquisition review, or “PAR”. We try to schedule the PAR’s about a year after the initial investment.
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Nevertheless, I think all processes should be periodically re-examined for their cost and benefit. An ad-hoc analys is done to understand a problem or opportunity is more likely to translate into action than a quarterly report that gets generated because “we’ve always done it that way”. The former requires curiosity and intelligence, the latter bureaucracy and compliance. If the Operating Groups can learn from their acquisitions by some less burdensome method than PAR’s, I’m all for it.
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As we teach more people at CSI how to deploy capital, we lean on the accumulated data from our historical acquisitions to help maintain investment discipline. We have base rates for a variety of key operating metrics. Whether it is aneophyte investment champion arguing that a particular acquisition is “special”, or a senior executive being tempted by a large acquisition, we have enough data to make the discussion rational, not emotional. We all know whether the key assumptions are being pushed to the 55th or 95th percentiles of our historical distributions. My only significant concern regarding investment discipline, is that we’ll be tempted to drop our hurdle rates as our cash balances climb.
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Avoiding Overhead Creep:
Overhead creep is a short-term concern of mine and the BU Managers. It is human nature to build empires. The slippery slope looks something like this: I add value to the CSI Operating Groups and BU’s, and CSI is doing well, hence the expenditures that I make at head office are justified. Our Operating Group Managers add value to their BU’s, and their Operating Groups are doing well, hence their expenditures are justified (although they find the expenditures at head office questionable). The Portfolio Managers who work for the Operating Group Managers add value to their BU’s hence their expenditures are justified, etc.
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The only way we’ve been able to consistently stifle overhead growth at head office is to arbitrarily limit headcount additions. That has allowed us to reduce the head office burden from 3.0% of Net Revenue in 2004, to 0.5% last year. We hope it will be lower in 2017.
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I have struggled to find a less arbitrary means of appropriately sizing overheads. A couple of years ago, our head office tax folks seemed to have an insatiable appetite for increased headcount. I couldn’t argue with their justification, but I asked them to start billing the Operating Groups for the incremental services, separate from our normal overhead allocation. There were two short-term results… our head office tax people hated billing the Operating Groups and justifying their bills, and one of the Operating Groups went off and hired their own tax person. The long-term result also pleased me: the head office tax people have stopped asking about hiring additional staff. Now, if I could just figure out how to stop them spending all that money with outside tax consultants.
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One of my research acquaintances says that most people keep torturing the data until it confesses. In this instance, we can do that… we can make a case for “small is beautiful”. Our businesses with fewer than 100 employees are a tiny bit more profitable and have a bit more organic growth. Unfortunately, we can flip that finding by excluding only a couple of outlier datapoints. Despite the lack of compelling data, I believe that small BU’s are more manageable and do a better job of serving clients in the VMS industry. Sometimes belief and gut feel are all you have, and you must act upon them until there’s more evidence to influence your thinking.
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CSI’s strategy is to be a good owner of hundreds (and perhaps someday thousands) of growing autonomous small businesses that generate high returns on capital. Our strategy is unusual. Most CEO’s of public companies would rather run a single big business -perhaps two or three big businesses, but rarely 200 businesses. They expect (or hope) to get above average returns on capital by pursuing economies of scale and by crushing or acquiring their smaller competition. “We are #1 in this large and growing market” is their normal aspirational paradigm. It’s also a formula with which shareholders, analysts and boards are comfortable. We recognise that economies of scale, centralised management and world class talent competing in large and growing markets can be a great business-building formula. But, it isn’t what we do. We seek out vertical market software businesses where motivated small teams composed of good people, can produce superior results in tiny markets.
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All the employees know each other, and if a team member isn’t trusted and pulling his weight, he tends to get weeded-out. If employees are talented, they can be quirky, as long as they are working for the greater good of the business. Priorities are clear, rules are few, trust and communication are high, and the focus tends to be on how to increase the size of the pie, not how it gets divided.
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The more likely outcome, is that the R&D manager isn’t a brilliant workaholic and cannot cope as the team size exceeds double digits. Instead, he’ll break his team up into multiple teams. A new level of middle managers will be born, with all the potential for overhead creation, politics, and bureaucracy that comes with another tier of middle managers.
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The larger a business gets, the more difficult it becomes to manage and the more policies, procedures, systems, rules and regulations are generated to handle the growing complexity. Talented people get frustrated, innovation suffers, and the focus shifts from customers and markets to internal communication, cost control, and rule enforcement.
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I believe that CSI can be a great home for an owner-managed business. If the business has more than a handful of employees, we nearly always run it as a stand-alone BU.
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I have a bias towards developing our Portfolio Managers internally or having them join us via an acquisition. Our best managers have risen through the ranks and developed a following. When they make it to BU Manager, they act like they “own” their BU and they stick with it. They have career-spanning relationships with their employees and their clients. They feel responsibility heavily…… It starts small. It’s incremental. It’s slow, but over the course of a long career their mastery, satisfaction, wealth and the number of their followers, all compound.
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Some businesses get their unique advantage from government-granted monopolies, some from natural resources, some from large patent portfolios, and some from enormous fixed assets. CSI doesn’t have these advantages. Our employees, and the customer relationships that those employees have built and fostered over many years, provide our competitive advantage.
2017 letter:
I used to write quarterly letters to shareholders. After a few, I switched to annual letters. There is an archive of them on our website. It contains most of what I can tell you about investing in Constellation. In the future I will only write to shareholders when I think I have something new and important to communicate.
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The return on our shareholders’ Average InvestedCapital (“ROIC”) dropped to 29% in 2017. The decrease was a function of a slew of new investments with lower ROIC’s and of our increasing cash balance. I expect this metric to continue to drop.
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Competition for acquisitions has increased, as has our FCF, so it is unlikely that we will be able to invest all of our FCF at attractive returns over the next decade.
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Almost half of our shares trade each year, which suggests that many of our shareholders are not long-term oriented….. There is another class of long-term Constellation shareholders who invest time and effort to get to know our company and may even try to contribute to its growth and prosperity. We are fortunate to have a couple of dozen institutional investors, several hundred personal investors and several thousand employee shareholders who have taken this view.
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Qualified and competent Directors are very rare, and not surprisingly, the track record of most boards is awful.
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We believe that when you limit a competent Director’s term, you limit their opportunity to learn and hence to add value……. We’ve been searching for great Directors for years. We’ve gone on long campaigns to land individual candidates whom we admire. One observation from those frustrating pursuits is that a lot of high quality people don’t want to be Directors. They may be intrigued by the company and the managers and the business philosophy. Despite that, the “policing” responsibility is an unpleasant one, and the prospect of investing a huge amount of time to learn the business and win management’s trust and respect is daunting…… The current movement to limit Director tenure makes great sense if you think your investee company is poorly governed. However, if you think the governance is good, then limiting Director tenure hurts the company. It is analogous to firing a high-performance employee on their tenth anniversary.
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Constellation has some intelligent, curious and irreverent employees who regularly challenge management’s fondly held assumptions and beliefs. We don’t appreciate those employees enough.
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I am suspicious of “vision”. Long-term studies suggest that the underlying predictions or assumptions for visions are nearly always impractically vague or outright wrong (see Tetlock’s “Superforecasting”). I am not much happier with the term “mission”. It feels too heavily freighted with overtones of hierarchy and unquestioning compliance.
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As perpetual owners, we care about the long-term health of our many small businesses. We try to provide an environment in which they can flourish. The primary way we can do that is by making sure that they have high-quality managers who are compensated according to rational long-term oriented incentive programs.
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One day Constellation may find that VMS businesses are too expensive to rationally acquire. If that happens, I hope we’ll have had the foresight and luck to find some other high ROE non-VMS businesses in which to invest at attractive prices. I am already casting about for such opportunities. If we don’t find attractive sectors in which to invest, then we’ll return our FCF to our investors. Even if re-investment opportunities becomes carcer, Constellation doesn’t end… it will continue to be a good (hopefully great) perpetual owner of its existing VMS portfolio, and will still deploy some capital opportunistically.
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I try to make sure that sycophants, spin-doctors, and mercenaries don’t survive in Constellation’s senior ranks. Harder, but not impossible, is helping identify and remove hidebound managers who rely upon habit and folklore to run their businesses rather than rational enquiry and experimentation.
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I find there is no magic to managing and leading. If you are smart, work harder than everyone else around you, treat people fairly, do not ask them to do anything you would not or have not done, share the credit, keep learning and keep teaching, then pretty soon you have followers. If you make sure that the team members are intelligent, energetic, and ethical people with whom you would want to work for the rest of your career, it won’t be long until you are running one of our BU’s.
2021 letter: Changes in capital allocations
One of our directors has been calling me irresponsible for years.His thesis goes like this: CSI can invest capital more effectively than the vast majority of CSI’s shareholders, hence we should stop paying dividends and invest all of the cash that we produce, even if it means lowering our hurdle rates.
What have we done with that excess free cash flow available to shareholders(“FCFA2S”)?Historically, wehave paid three specialdividends, and for the last decade wehavealso paid a regular quarterly dividend.I have stopped arguing.I have converted, and with the fervour of the newly converted, Iambusy demonstrating my new-found faith.
The obvious first step is to stop specialdividends in all but the most compelling circumstances. That decision was made by our directors at Friday’s CSI board meeting. Wehavemaintained the quarterly dividend for now, but if we are successful in finding better uses for ourFCFA2S, the quarterly dividendwill also be sacrificed.
Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.
