Constellation Software (TSX: CSU) and Open Text (TSX: OTEX) have both outperformed the Canadian stock market in the long run. Which is a better buy today? Let’s take a look.
Source: Getty Images
Past returns
Past returns may be indicative of future returns. When comparing their total returns in the last decade, Constellation Software is indisputably the best buy. In this period, the Canadian stock market, using iShares S&P/TSX 60 Index ETF as a proxy, delivered a compound annual growth rate (CAGR) of about 8.3%, while Constellation Software and Open Text returned 33% and 12.8%, respectively per year.
Constellation Software’s returns were supported by adjusted earnings per share growth at a CAGR of 23.3%, while Open Text’s adjusted earnings per share grew at a CAGR of 11.8%. It implies that Constellation Software has experienced meaningful valuation expansion, as investors recognized that it was a top tech stock.
XIU, CSU, and OTEX Total Return Level data by YCharts
Volatility
Interestingly, Yahoo Finance indicates that Constellation Software stock has a recent beta of 0.85, which means it is less volatile than the market, which has a beta of one. Then there’s Open Text stock with a similar beta to the market.
Indeed, Open Text stock can make a meaningful dip or jump on any given day. For example, yesterday, the stock dipped more than 4%, but there was no news from the company. Constellation Software stock also dipped on the day but with a much more palatable drop of just over 2%.
Valuation and dividend
Constellation Software management has been excellent at allocating its capital, driving five-year return on invested capital and return on equity of about 25% and 45%, respectively. The company primarily allocates capital in growth opportunities, which is why it pays a puny dividend yield. Still, long-term shareholders must be happy with the price appreciation they have experienced.
At $2,784.73 per share, Constellation Software trades at a whopping valuation of about 36.6 times adjusted earnings. However, it’s also expected to grow its earnings per share by approximately 29.6% per year over the next three to five years. Analysts think the stock is fairly valued.
Open Text is digesting the massive acquisition of Micro Focus. The uncertainty in integrating the operations and paying down the elevated debt levels is partly what is depressing the stock. At $50.09 per share, the information management tech stock trades at about 10.4 times adjusted earnings. As the company reduces its debt levels and makes progress in the integration, the stock should experience valuation expansion. It targets a net leverage ratio of below three times by the end of fiscal 2025.
Assuming a reasonable price-to-earnings multiple expansion to 13.4 times, it would equate to upside of about 29%. Currently, the 12-month analyst consensus price target suggests a discount of 25%, or near-term upside potential of 33%, which aligns with the upside prospects related to the multiple expansion.
Open Text has a track record of growing its free cash flow, which has translated to increasing dividends for a decade. Its five-year dividend-growth rate is 12.7%. At the recent quotation, it offers a dividend yield of about 2.7%. It has room to continue dividend growth, though in the near term, it will focus on debt reduction.
Investor takeaway
If you want better predictability, Constellation Software is a better buy. The market is confident in its ability to deliver, seeing as it trades at a significant premium to Open Text. For a better value play that could potentially lead to strong gains over the next few years, consider Open Text, especially on meaningful dips.
