Constellation Software is a technology company that operates by purchasing small software companies, that serve a large range of industries. CEO Mark Leonard started the company in 1995 with $25m in venture capital. He took the company public in 2006 at $17 and the shares now trade hands at over $700. CSU has been the most successful stock on the TSX over the past 10 years and still flies under the radar for most analysts and portfolio managers.
CSU is a classic stock for what we’re looking for. They are tremendously consistent ROE generators but their reported net income is relatively low. Admittedly this had kept us away from the stock before we conducted a deep dive into their financials and we regret this however, it has taught us a VERY important lesson. Whenever I mention CSU (or DOL for that matter) to colleagues, the very first comment I hear is ‘yes, the stock has done well but, it’s really expensive!’ The trailing price earnings ratio of CSU is 49 which is very high indeed. However, the cash PE ratio of CSU is a much more palatable 22 as noted in the table above. It is also low in relation to their superior ROE metrics. By our measure, Dollarama (DOL) and CSU are the #1 and #2 profitable companies in Canada.
To derive the cash PE ratio for a company, one must add non-cash items back to net income. When CSU buys a software company, most of the money goes towards ‘goodwill.’ Most software companies’ value their software (not really a physical asset) and their head count (employees). They rarely have much in the way of fixed assets. So, the difference between the purchase price and fixed assets is booked as goodwill. They can amortize this goodwill over time which serves to reduce their reported income (for income tax purposes). It however does not reduce their cash flow and that’s what we’re most interested in, CASH generation! CSU is a cash cow and while there are questions as to whether they can maintain their acquisition pace, and with increased competition we remain confident in the management team. They have never issued a share, given themselves options or raised capital that was dilutive to shareholders. The only money they have ever raised was via a unique debenture offering which we also participated in. In short, Mark Leonard and his management team are hands down the most efficient and effective capital allocators in Canada.
The chart below shows the incredible performance of CSU shares over the past 10 years. We will note that it spent the better part of 2015 and 2016 consolidating and now appear to be breaking out again.
Mike Preto and Jason Del Vicario are Investment Advisors at HollisWealth, a division of Scotia Capital Inc. Based in Vancouver, BC, Canada, they work together in bringing a unique approach to managing money to ensure their clients are financially prepared for their retirement. They can be reached at 604-895-3349.
This article was prepared solely by Michael Preto & Jason Del Vicario who are registered representatives of HollisWealth® (a division of Scotia Capital Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada). The views and opinions, including any recommendations, expressed in this article are those of Mike & Jason’s alone and not those of HollisWealth. ® Registered trademark of The Bank of Nova Scotia, used under licence.
This post is for informational purposes only. There are risks to investing in stocks and investment decisions must take individual circumstances into account. Please consult a professional advisor.