Subject: Re: Constellation Software - CNSWF
I’ll be extremely brief on this one:

No AI here!

- Quote in slow motion free fall as investors exit after CEO Leonard resigned for health reasons. In my research his departure isn’t that important because the capital allocation has been distributed years ago away from Leonard.
- Further selling pressure from paranoia that AI will replace the need for their software. This reason is very naive when you are familiar with specialized vertical software. I estimate AI hype will be a net benefit for organic growth as it will stimulate auxiliary upgrades but the systems (flight scheduling, travel booking, insurance brokerage and billing, etc) cannot be replaced.
- They are more than anything a value investing compounding machine and have compounded 30%+ the last 20 years. That wasn’t a typo. In recent years compounding around 20%.
- Their circle of competence is small/ medium specialized vertical software companies. I know this industry well and revenue is insanely sticky. It will take a longer post to explain that. So what they do is buy with a return on invested capital in the 20-30% range.
- They get such a high 20-30 percent return range precisely because they are buying firms that generally dot *not* grow revenue but just sustain it with 20-40 year life cycles - so is like buying infrastructure or property, but with much higher revenue/cost ratios. So there is really high growth by acquisition but almost no organic growth. That is deliberate. The zero organic growth *is* what allows them to acquire at such a low multiple to get the 20-30% return on invested capital.
- They also do deals that allow the seller to continue programming independently without interruption in most cases. Part of their most is the trust they earned for allowing extreme autonomy for the software firm being purchased. Berkshire shareholders who have seen interviews with owners of their acquired firms will get this.
- Unlike other growth by aqusition firms, which are centralized for capital allocation even if when allow their purchased firms to run independently - Constellation uniquely allow extreme autonomy for *both* the acquired firm, and also the capital allocation process itself. Buffett allows capital allocation autonomy with just two investors but Constellation Software have applied this autonomy in an systematic way and they have proven that it works for years, with Leonard involved in fewer and fewer deals himself but the huge returns on capital having continued.
- So they have over 500 software firms and several separate capital allocation companies between constellation and the small software firms, each with a slightly different culture; but the same extremely disciplined value investing mandates. If a candidate cannot be acquired with a ROIIC of more than 20% it is skipped instantly. Their database of candidate firms has more than 50,000 firms.
- Do not price by EPS (thus ignore PE) as they use amortization to lower the earnings (with a bonus that they pay lower tax) and hold what they buy forever -- to an even more extreme degree than Berkshire. They grow not by the software firms charging more over time, but by using all the cash flow to chase very high return on invested capital. So value them by free cash flow; both rate of cash flow growth to represent how they are growing; and combine that with price to free cash flow ratio to gage your own return from the shareholder perspective.
- Can buy today at under 20 x free cash flow; peaked at 37x, and had usually been around 25x (though lower than 20x prior to 2015 when the market was still working them out) So your investment return from here should be similar to their return on incremental invested capital (ROIIC) presuming they don't trade greatly under 20x free cash flow when you want to sell.
- This is the kind of firm you hold really long term, but in recent years it has been impossible to get it at reasonable cash flow multiple.

I would anticipate continued downward falling knife effect for a few months, but any purchase from now (around 20x free cash flow or lower) should give 15-20% returns over the next 15 years or so, with some multiple gain plus acquisitions continuing at 10-15% ROIIC for a couple of decades.

Ok I wasn’t so brief.. but just wanted to cover the crucial factors.

- Manlobbi