Constellation Software’s Agnostic Capital Allocations
Constellation Software’s CEO Mark Leonard is a bit of an eccentric character and CEO. Under his reign, the company has compounded at about 40% for almost two decades! We have been avid readers of his annual shareholder letter for years, but unfortunately, he has chosen only to write when he has something “important to write”. We have summarized the main points from his shareholder letters in this article:
On the 15th of February 2021, he published a recent letter that started like this:
One of our directors has been calling me irresponsible for years.
A start like this automatically attracts the attention of the reader. Why has Mark Leonard been irresponsible?
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.
Constellation’s business model is to acquire small software companies under one umbrella while giving them autonomy without fiddling from HQ. By small, we mean acquisitions below 100 million in niche businesses. But with time, the company gets so big that small acquisitions won’t move the needle very much. To change this, the director who called Leonard irresponsible suggests skipping the dividends and instead do more significant acquisitions. Leonard has been against this because he wanted a higher hurdle rate, ie. higher returns on capital employed. Buying bigger companies most likely leads to lower returns on capital. The point is, Constellation can still produce higher rates of return than most investors get on their reinvest of the dividends.
Leonard has made a U-turn and says Constellation will no longer pay special dividends to accommodate for bigger acquisitions. Moreover, he’s considering skipping the regular dividend as well. As shareholders, we applaud that.
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 special dividends in all but the most compelling circumstances. That decision was made by our directors at Friday’s CSI board meeting. We have maintained the quarterly dividend for now, but if we are successful in finding better uses for our FCFA2S, the quarterly dividend will also be sacrificed.
External vs. internal compounding
Skipping the dividend is good news for shareholders. First, Constellation can reinvest the retained earnings at better rates than the majority of the shareholders. Second, by “dripping” or reinvesting the dividend, you take a beating by doing so. To understand why, please read these two articles:
Instead of a dividend, you can sell shares to get “income:
Leonard’s U-turn requires “quality” shareholders:
Leonard’s U-turn could not be done in many dividend-paying companies. The reason is that a dividend gets typically “sticky” – hard to remove:
If you do not have potential high-return investment projects, consider paying dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
– The Outsiders, William Thorndike.
A regular dividend becomes hard to undo or reverse. First, many shareholders invest because of the dividend. Dividend investing seems more popular now than ever before, and for dividend investors, a dividend cut is bad. A whole business is occupied with finding the best dividend stocks, and obviously, many companies tout their dividend track record as one of the main reasons for investing. Very few dividend cuts happen unless the company is forced to (because of deteriorating fundamentals).
Warren Buffett has spent considerable time in attracting shareholders that think like owners. Most dividend investors don’t think like owners. Dividend investors are not agnostic, they don’t consider the opportunity cost of the retained earnings:
Where does your capital compound the most efficiently, in the pockets of the shareholders or in the pockets of the company?
Leonard has in his letters written that you get the shareholders you deserve. We believe he is right.
Disclosure: We own shares in Constellation Software. We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.
