Constellation Software's Influences: An Overview of High Performing Conglomerates

Mark Leonard is known for his legendary shareholder letters and even more legendary returns he has generated for decades since founding Constellation Software. Leonard recently stepped away from Constellation Software due to health reasons, and it nudged me to put together a post I’ve been meaning to write for some time.

For those not familiar with Constellation Software, please refer to a post we wrote back in 2021. The short version is after working in venture capital for a number of years Mark Leonard founded Constellation Software to acquire and own high-quality vertical software (VMS) businesses.

In his 2016 shareholder letter Leonard introduced the term “high performing conglomerate” (HPC). At CSU, the management team studies other successful businesses and reviews what they find with group managers as a way of improving their own strategy. Formalizing their study of HPCs gave leadership a clear picture of what type of business they wanted to be as they scaled. As Leonard explained:

“We focus on high performance conglomerates that have demonstrated at least a decade of superior shareholder returns. We started by studying those that have generated superior returns for multiple decades. That narrowed the field a lot, so we are beginning to let some single decade performers slip into the candidate pool. I’ll refer to the conglomerates that we’ve studied to date as the “HPCs” in this letter... Constellation Software Inc. (“CSI”) is just entering its third decade. We study the HPCs because they help us understand what CSI does well, where we might improve, and what alternatives we could pursue.”

The eight original HPCs that Leonard and his team studied and attempted to learn from and emulate were:

• Ametek

• Danaher

• Dover

• Illinois Tool Works

• Roper Technologies

• Jack Henry & Associates

• Transdigm

• United Technologies

These businesses serve a diverse array of end markets but share many commonalities.

With the exception of United Technologies, all of the companies are still public in largely the same form as when Leonard studied them. I thought it would be a fun and instructive exercise to take a tour of each HPC and put together a short description of the businesses today to explore the common threads between them.

I’ll focus mostly on the qualitative aspects of the businesses that have led to outstanding quantitative financial results for the companies and their shareholders.

Overview of each HPC

Ametek

Ametek manufactures products in the electromechanics and electronic instrument industries. The company operates two segments, EIG and EMG.

The EIG segment designs and manufactures advanced analytical and test measurement instruments for the aerospace, medical, power, and other industrial markets. They specialize in process control and monitoring equipment; products that are critical to the processes in which they are used and have a high cost of failure.

The EMG segment is a leader in the design and manufacturing of highly engineered medical components and devices along with automation solutions, thermal management devices, and specialty metals. Many of these products are single-use and consumable surgical instruments or are used in drug delivery systems.

While the business has an extremely wide range of products, they generally share similar characteristics. Ametek has significant market share in niche markets and has built its portfolio of offerings largely through acquisitions. Management targets high single-digit revenue growth, double-digit earnings growth, and closely watches returns on capital and cash generation.

Danaher

Danaher is a business many investors are familiar with as it’s a classic acquisition-focused compounder. The business today consists of three segments; biotechnology, life sciences, and diagnostics. In each segment Danaher supplies a wide variety of testing and analytical equipment. Most of its product lines include substantial consumables products – think of the materials that are used when performing an assay in an analytical laboratory.

Danaher has an extremely diverse customer base and likes recurring revenue products that are sold directly to customers rather than through distributors.

The business is perhaps most well known for its Danaher Business System (DBS) which is Danaher’s take on the Toyota Production System (TPS), also known as Lean manufacturing principles. For decades Danaher has acquired a myriad of businesses and continuously wrung out costs once they join Danaher. The results are high and increasing returns on capital and significant cash flow to reinvest in further acquisitions.

Dover Corporation

Dover is a diversified manufacturer that sells equipment, consumables, aftermarket parts, and software solutions through five segments: engineered products, clean energy & fueling, imaging & identification, pumps & process solutions, and climate & sustainability technologies.

The company sells to thousands of customers and provides products such as automotive and aerospace aftermarket parts, specialized transportation and dispensing solutions for fuels, RFID and coding tags, fluid transfer connectors, and parts for commercial refrigeration. Like most of the HPCs, the product catalog is all over the map, but they all tend to be technical and specialized in nature. The company prefers low capital intensity product lines and emphasizes selling critical components that are a small overall portion of the larger system cost. As they explain in their 10K:

“our industrial and biopharma pumps, biopharma connectors, engineered bearings and compression components, clean energy components, and heat exchangers are all part of larger systems built or employed by our customers. Such components typically serve demanding applications where value-in-use and costs and risks of switching far exceed the cost of the component itself.”

In other words, their customers often have high switching costs given the cost of failure relative to the cost of the component.

Dover emphasizes selling products that are highly engineered and require a significant and predictable volume of parts, consumables or services over their lifespan. A large installed base in each segment results in significant recurring and high-margin revenue.

In a theme you’ll see throughout this post, particularly with the businesses that have built their product portfolio mainly via acquisitions (like Dover), management runs the business in an extremely decentralized fashion, focuses on continuous improvement, and optimizes for returns on capital rather than revenue growth. The company states that they target a rather modest 4-6% revenue growth. Remarkably, Dover has raised its dividend for 69 consecutive years while returning over 41,000% for shareholders.