It has been almost three years now since inflation became rampant and rate hike fears started to weigh on markets. So, since August 2021, equities have been reeling under pressure and lost considerable market value. TSX tech stocks are trading 20% lower than their August 2021 highs. However, one stock that has remained quite resilient to all these macroeconomic challenges is Constellation Software (TSX:CSU). CSU has, in fact, gained 23% in the same period, notably beating peers and broader markets.
Constellation Software stock continues to outperform
As interest rates started to move up, richly valued stocks started to slide. That’s because as discount rates increase, a company’s present value of future cash flows also comes down, making them less worthy. As a result, tech stocks that offer higher growth potential, in general, see an exaggerated impact amid a rising rate environment. However, in the case of Constellation Software stock, there was a minimal fall, despite its rich valuation. It still trades at 80x–90x earnings, indicating market participants’ faith in the growth prospects.
Moreover, it is Constellation Software’s exceptional business model and consistent profitability that warrant its premium valuation. Very few companies have managed to grow at an above-average rate for such a long period. For example, its net income on a normalized basis has grown by 20%, compounded annually in the last decade. Shareholders, in turn, saw massive wealth creation thanks to such steep financial growth. CSU stock returned 2,000% in the last decade, while TSX tech names returned 415% in the same period.
What’s so special about Constellation Software?
It is Constellation Software’s differentiated business model that’s behind such a performance. It acquires smaller vertical market software companies that have a leadership position in their particular domain. Vertical market software companies cater to a niche customer class as opposed to those that serve the masses.
Constellation Software has acquired more than 500 companies since its foundation. It makes tons of free cash flow from the existing portfolio, which is deployed for buying new companies and the cycle goes on. This playbook has worked very well for Constellation and its investors all these years.
Even though Constellation belongs to the cyclical tech sector, its margins have largely been stable. Its operating margins have averaged around 20% in the last decade. That’s a tad on the lower side, but the relative stability indicates superior earnings quality.
Moreover, Constellation has a healthy balance sheet even though the company is driven by acquisitions. The inorganic growth is funded mainly internally, and it carries manageable debt. At the end of Q4 2022, the tech company had a leverage ratio of 1x. Its relatively lower amount of goodwill, higher liquidity position, and minimal debt speak to its balance sheet strength.
Investor takeaway
CSU stock is currently trading at its all-time high. Its richly valued stock might keep conservative investors at bay. However, the valuation seems justified, given its outperformance in the previous bear markets and consistently strong execution. The stock will likely keep creating shareholder value with its accretive acquisitions and free cash flow growth in the foreseeable future.
