Not many stocks in Canada have turned a $10,000 investment into $1 million or more. Likewise, almost no stocks have turned $10,000 into $1 million in 15 years or less. Well, except for one Canadian stock that many investors still don’t even know about. That Canadian stock is Constellation Software (TSX:CSU).
One of Canada’s best stocks, and many still don’t know about it
If you bought Constellation Software stock in 2008 (a couple of years after its initial public offering (IPO)) and held onto your shares today, you would be sitting on a 12,756% total return. That translates to an average annual total return of 38%.
A $10,000 investment in Constellation stock would be worth $1.285 million today. Its returns are actually even better. That total return doesn’t account for the spin-offs of shares in Topicus.com and Lumine Group. Those stocks have respective market capitalizations of $7.5 billion and $1.95 billion.
Despite the spinouts, Constellation stock has only continued to grow in value. Both spinouts trade at premium valuations to Constellation. This just demonstrates the quality and value of the businesses that it develops.
What does Constellation Software do?
Constellation is, like its name, a constellation of hundreds of small, vertical-focused, niche software businesses. Unlike horizontal software platforms (say, like Microsoft) that have broad business applications, Constellation’s businesses serve specific customers or markets.
These tend to be essential business platforms for their specific customers. As a result, revenues tend to be very sticky and resilient through market cycles.
Constellation has dialled in an operating model that enhances profitability and yields significant spare cash. It manages a fine balance of growing the businesses, but only enough to maintain profit margins and maximize cash generation.
Generate cash, buy businesses, rinse, and repeat
With the excess cash, Constellation acquires more niche software service businesses. The company has a decentralized operating model that allows leaders across the organization to participate in the M&A (mergers and acquisitions) engine.
Year to date, Constellation has acquired 100 businesses into its fold. Many estimate that it has a database of 100,000 potential acquisition candidates. Even though this stock has 100X’d in 15 years, it and its spinouts could still have substantial growth in the years ahead.
Constellation has grown its earnings per share and free cash flow by a ~23% compounded annual growth rate over the past 15 years. Both those profitability metrics have increased by 6.7 times over that period.
Never cheap but perhaps fairly valued
Now, given its strong growth, great execution, and exceptional capital allocation, Constellation stock trades at a steep valuation. It trades with a price-to-earnings (P/E) ratio of 96! Now, that is deceptively high. Constellation must deduct a large level of non-cash amortization from its earnings because of the elevated level of acquisitions it does.
If you look closer at its price to free cash flow (which some suggest is a better metric of profits for Constellation), it trades for 23 times. That is not unreasonable, given its strong performance to date.
The stock has had a late steep run-up in the back half of the year. I would still not call Constellation cheap, but its valuation is not at nosebleed levels.
Still good returns ahead
Given its market cap of $67 billion, it is safe to believe it won’t 100X again. However, it is reasonable to believe that it could still provide market-beating 15-20% compounded annual returns for several years ahead. If it keeps spinning out attractive mini-Constellations, you may do even better (especially if one of those smaller businesses 100X’d one day).
