Founders - #246 Mark Leonard's Shareholder Letters

Starting point is 00:00:00 Mark Leonard reminds me of Warren Buffett. Anyone who likes reading Berkshire shareholder letters will enjoy Leonard's. The Globe and Mail describes part of what Leonard has accomplished at his company, Consolation Software. With an initial $25 million investment in 1995, Mark Leonard has built Consolation into a world-leading consolidator of vertical market software companies. These are companies that create products to help run businesses in specific industries. Over the years, Constellation has acquired over 500 businesses. Typically, Constellation's acquisitions are small,

Starting point is 00:00:36 in the $2 to $4 million range. But add them all up, slip in a dose of Constellation's financial and operational discipline, and you have a company with a market cap of $40 billion. In this age of zero privacy, Mark Leonard has managed to maintain a practically unthinkable level of anonymity for just about any individual, let alone an executive who runs one of Canada's most dynamic and fastest growing software companies. That was an excerpt from a blog post about the founder of Constellation dynamic and fastest growing software companies.

Starting point is 00:01:08 That was an excerpt from a blog post about the founder of Constellation Software, which is Mark Leonard. I just spent the last several days reading every single one of his shareholder letters, and so that is what I'm going to talk to you about today. And so Mark's interesting for a number of reasons. One, I just touched on in that excerpt, he took a $25 million investment almost 30 years ago and has compounded it over what 27 years to a 40 billion dollar market cap. I'm obsessed with people that found and run the same company for a long period of time. Based on my math Mark was 39 when he started the company and he's still working on the company and he's 66 years old today. What also makes him interesting is that he's a recluse.

Starting point is 00:01:42 There's only one photograph that you can find online of what he looks like. He actually looks strikingly similar to Rick Rubin. And so outside of the occasional underground podcast that you might be able to download on like the dark web, the only way to get information about him is to read his shareholder letters or listen to his investor calls. And I just love the idea of this super smart genius who's just like, I don't need to speak. My numbers speak for themselves. And so the way I actually learned about Mark Leonard is actually through my friend Liberty. My friend Liberty runs one of the only newsletters that I actually read. I read like two newsletters. His is one of them. I'll leave a

Starting point is 00:02:19 link down below, but you can go to libertyrpf.com and you can check it out. And it was through reading his newsletter for many years because Liberty's been studying Mark for almost a decade. And so he was the one that helped me organize all the research and all the information that I used as the basis for the podcast. And so before jumping into some highlights from his shareholder letters, I want to pull out this quote that I heard Mark say on this podcast that's not publicly available.

Starting point is 00:02:42 And so Mark was asked the question, like, why is decentralization, autonomy, and control so important to constellations? And so Mark was asked the question, like, why is decentralization, autonomy, and control so important to Constellation? And so Mark's answer to this question, you clearly see, okay, this guy's a misfit. He's gonna fit right in on Founders. So it says, why are decentralization, autonomy, and control so important to Constellation?

Starting point is 00:02:56 Where did that come from? And Mark's answer was fascinating. He says, it starts with personal preference. I don't like anyone telling me what to do. I don't like anyone saying I'm an authority figure and you will do it this way. I can't think of anything that annoys me more. So he's talking about I'm building a system that I want to work in. Not only that, but I want to attract other people that are like-minded. And you'll find that highly talented people are not going to want to work under a highly centralized command and control business. So he's talking

Starting point is 00:03:23 about, you know, this was a personal preference. I don't like anyone saying I'm an authority figure and you will do it this way. I can't think of anything that annoys me more. I was struck by principles, meaning when he grew up, I guess he meant like they literally hit him. I challenged teachers. I left home early. I had a bootleg radio license. I built a flamethrower. I did things that were not accepted by lots of other people. The ability to choose what I think is right is something I prize highly. Okay, so let me jump into his first shareholder letter. And he says, the software business has significant economies of scale.

Starting point is 00:04:02 He says, history suggests that we generally grow our acquired businesses frequently, by frequently providing additional products for them to sell into their install base. So we've made money by selling existing customers more products. And then another way he talks about that how they make money is occasionally, however, the reduction of an acquired business, so a business that we bought to a profitable core will leave us with a smaller, but usually more profitable business. So the way I interpret that, we also make money by making companies more efficient. So this really made me think of what Rick Rubin said. He's like, it's production by reduction.

Starting point is 00:04:34 I enhance things by removing everything that's not its essence. And so in his shareholder letters and everything that I've found online about Mark Leonard, talks about, hey, let's take something that's big and let's break it down into more manageable pieces. It's very similar. I read this interview with Henry Singleton, one of the very few ones that he did in Forbes in the 1970s. And it says Teledyne, which is Singleton's company, grows bigger by dividing businesses into smaller parts wherever possible. Singleton claims that this keeps his managers creative and not wasteful. Back to Mark's letter. This is going to sound exactly, I mean, he's going to write this, but this comes directly from Buffett's shareholder letters. Our preference is to acquire businesses

Starting point is 00:05:15 in their entirety and to own them forever. And if they can't buy a business and keep it forever, they are open to buying small parts of the business. It says, occasionally we have the opportunity to buy a piece of a good business with the prospect of eventually acquiring the rest. And so this is something he's going to repeat over and over again. Again, this is just the blog post I read, and I'll link it down below at the very beginning. You know, the very first sentence is, Mark Leonard reminds me of Warren Buffett. I read that blog post after I read his shareholder letters, and I came to that same conclusion. I'm often asked why Constellation takes minority interest in other public software companies. The answer is simple. Value.

Starting point is 00:05:49 Constellation's objective is to be a perpetual owner, there's that word again, of inherently attractive software businesses. Part of a perpetual owner's job, so his job, is to make sure that energetic, intelligent, and ethical managers are running their businesses, and that the managers are incentivized to enhance shareholder value over the very long term he's writing this in 2008 so he says we brought more we so far we have bought more than 70 private software businesses outright that number i said uh at the very beginning is over 500 now on 10 occasions however we have also participated in the purchase of a significant minority positions in public software businesses. So exactly what Warren says, it's like, by preference,

Starting point is 00:06:28 I want to own the whole business. Sometimes I realize, hey, pieces of business can be purchased attractively in public markets. So I will do that as well. So then Mark describes why the strategy is effective and what he's trying to do here. We have the same objective when we buy a piece of a business as when we buy 100%. We want to be a great perpetual owner of an inherently attractive asset. It's very obvious if you read his shareholder letters that he's receptive to new information, he's going to change his mind. And so we're in 2008 shareholder letter, obviously, there's a gigantic financial crisis that was occurring at this time. And he's going to say something here that's really interesting, because he changed his strategies in the future as well. So before they avoided debt.

Starting point is 00:07:06 And now he's like, well, the market has depressed assets. The assets are going selling for a lot less than we think the value is. Maybe I should take on debt just so I can buy those assets. Until recently, we have avoided using significant amounts of debt. Circumstances, however, may dictate a change in our capital structure. The economy is slow. Credit and equity markets are in rough shape. And buyers for vertical market software, which is what we're trying to be, buyers for vertical market software businesses are increasingly scarce. So now my company later on, he's going to talk about this

Starting point is 00:07:37 is getting a lot more difficult because people are realizing that the idea that we have an idea that other some other conglomerates, that VMS businesses are extremely attractive. Now, as that idea gets spread, I have more and more competition. In 2008, he's like, the downturn in the market and in the overall economy has kind of eliminated my competition. This is going to be for a very short amount of time. I should act is the way I think about what he's saying here. So it says quite a number of these businesses are for sale at attractive prices. We may not be the successful bidders of these assets, but if we are, we will almost certainly be increasing Constellation's financial leverage. And he knows

Starting point is 00:08:14 why this is an opportunity because it's almost the reverse of the problem he had before. For most of the last decade, we struggled to find enough attractive acquisitions to consume our operating cash flow. We believe that the situation has now reversed and we are sorely tempted to buy as many attractive vertical market software businesses as and while we can. And that's why I would say, hey, I'm against debt, but maybe I should reverse that because now I have an opportunity of a lifetime. In the note I left myself here to my interpretation of as I read this, we avoided debt, but prices are too good and we will borrow money so we can buy what we feel are underpriced assets. Everyone else is scared. The time to act is now. And when I got to this section, one of my favorite, this paragraph

Starting point is 00:08:57 that I read probably three years ago, it's from the fish that ate the whale. It's founders number 37, one of the best books that you could ever read. And there's a paragraph in that book that I've never forgotten. And it describes a point in the career of Sam Zimuri, which is the entrepreneur and the founder that the book is about. And I really feel it's describing what is taking place during this time in history, but also specifically to Constellation's business. So I'm going to read this entire paragraph to you from The Fish That Ate the Whale. And it says, there are times when certain cards sit unclaimed in the common pile, when certain properties become available that will never be available again. A good businessman feels these moments like a fall in the barometric pressure.

Starting point is 00:09:36 A great businessman is dumb enough to act on them even when he cannot afford to. So back to his 2008 letter, he says, we don't like sharing sensitive information with competitors. The maxim I always use because that same idea comes up over and over again in the history of entrepreneurship is that bad boys move in silence. So let's go on to 2009. Most of the businesses in his ideal world, he's trying to buy private software businesses that were usually still run and managed by the

Starting point is 00:10:05 original founder. His competition for that is obviously is going to be private equity companies. So I just want to pull out a paragraph here because that was interesting where he's talking about the view of the entrepreneur that's running a software company and then the view of a typical private equity firm that wants to buy that and how they're both biased at opposite ends of the spectrum and how Constellation takes a different approach. Hopefully that makes sense once I read this to you. The toughest challenge in the software business is intelligently trading off profitability and organic growth. So the combination of that, you have to balance that, right? Many entrepreneurs have a huge bias towards growth at the expense of profits. That's one end of the spectrum. Most private equity-owned software firms have the opposite bias,

Starting point is 00:10:48 which means they're not worried about growth. They're essentially trying to squeeze that asset for every last dollar. So Mark is comparing and he's saying this is what entrepreneurs typically do and this is their bias. This is the bias that we find for a lot of our private equity competitors. This is how we think about that. At Constellation, we try to find an optimum position where incremental investment still generates

Starting point is 00:11:10 good incremental long-term returns. We think both approaches can be improved, meaning the approach of both the founder and the private equity. So really the note of myself here, my interpretation of what he's saying here, founders think that the future will be better if we are bigger. Private equity wants to squeeze every last dollar out now. And then once we get to the 2009 shareholder letter, this is where I

Starting point is 00:11:33 wrote, this is the very first time I start to understand what Mark is doing and what he's actually shooting for. And so he's talking about the benefits of having all these software businesses. And he's saying, in our businesses, we can nearly always grow revenues organically without incremental capital. And because he's getting more revenue, more profit without investing, having to invest more money, he takes those cash flows, buys more businesses. And that's how you're able to compound for a long period of time. But this is why he chose VMS businesses, because they typically have really low attrition rates. So he says, our attrition rates also illustrate the long-term nature of our client relationships. Attrition due to the loss of customers in 2009 was 4%.

Starting point is 00:12:11 This suggests that our average customer will stay with Constellation for 26 years. Customer relationships that endure for more than two decades are valuable. We have symbiotic relationships with tens of thousands of customers. We handle thousands of their calls each day and issue scores of new versions of mission-critical software each year. And so why would the customer stay on? Because for an annual cost that rarely exceeds one percent of a customer's revenues, our products help them run their businesses effectively, adopt their industry's best practices, and adapt to changing times.

Starting point is 00:12:52 And then he explicitly talks about why he has such a long-term bias. Why he's talking about he uses words like permanent. We're going to keep these businesses forever. We want to buy them and never sell. We have been a serial acquirer of inherently attractive small vertical market software businesses in a large number of different verticals. This is the punch line right here. The longer we have owned a small software business, the larger and better it has become. If we persist in this strategy, we will continue to add new verticals and make many more software or excuse me, many more acquisitions each year. So you're saying, okay, we've already bought what 60 or 70, wherever they were at this point, we know that they've done

Starting point is 00:13:28 over 500 in the next, let's call it 10 to 12 years. Now here's the problem. How, what it ties into exactly why he's, he's like this proponent of extreme decentralization and he hates bureaucracy. We've handled our growth to date by largely abdicating management to the managers of each of our vertical businesses. This is why people say he reminds them of Warren Buffett. We have a very thin overlay of infrastructure at headquarters, just like Buffett. We count on the fact that with each new acquisition comes with general managers who are steeped in their verticals, just like Buffett. Having owned more than 100 vertical market software businesses, we also have some best practices that we can share, just like Buffett. And so that's an important point.

Starting point is 00:14:13 Keep in mind, if you read these shareholder letters and you compare it to what I'm going to talk about on the podcast, you're going to see none of where he talks about return on investment capital, compound percentages, all this stuff. That's not why I am. I don't consider myself an investor, right? I read shareholder letters and I think about it from a founder's perspective. The reason I want to read Warren Buffett shareholder letters is exactly what Mark just talked about. We own a hundred businesses. We get to see their performance.

Starting point is 00:14:38 We get to see the ideas across a wide section. We can pull out ideas that what he's calling best practices, and we can share it with other people. want to read buffett because buffett's shareholder letters and his biographies and everything else because there's i haven't found another person that for over what let's see now 70 he started researching businesses when he was like 11 he's like 90 so it's called 80 years there's probably no one else on the planet that has spent more time analyzing a wide variety of businesses and he could tell us hey hey, this idea clearly works. I've seen it happen over and over again. And so I'm going after the exact same thing when I read Mark's letters.

Starting point is 00:15:09 Like how many people have built a business starting with $25 million investment, compounded it to $40 billion. He's been doing it for almost 30 years. He's bought 500 businesses. So that's the businesses he's bought, right? How many businesses has this guy analyzed? He's clearly going to have a lot of valuable information. And it's the same way when I, the reason I wanted to read, so I read the very first time I read anybody's shareholder letters, I read Jeff Bezos' shareholder letters. It's episode 71

Starting point is 00:15:34 of Founders, right? I did that episode, I don't know, three years ago. There's not a week that goes by that I don't get a message about somebody just now finding that episode and sending me messages about how much they liked it. And what I really loved is the description to that episode. And it says to read Jeff's shareholder letters is to get a crash course in running a high growth internet business from someone who mastered it before any of the playbooks were written. Just so you know what I'm shooting for is like, I'm just looking for ideas from people that have spent an enormous amount of time, three decades in this case, studying business. I want to know the business ideas that they found are great. So then we can pull them out and use them for whatever it is that we're doing during the day.

Starting point is 00:16:17 So moving on to 2010 letter, this one was really confusing. I was like, what is up with this letter? The company might be sold by who? What is happening? What is taking place here? There was some kind of shareholder revolt, but it was like light on the details. And he just has a line where he's like, I'm proud of the company that our employees and shareholders have built. And we'd be more than a little sad if it is sold. Interesting enough, that interview I heard, he's like, if any, give anybody advice that wants to run a public company, make sure that you get the shareholders that you deserve. Again, something that, that Buffett talks about all over and over again. But what's interesting, Constellation obviously wasn't sold. But I went and looked, I was like, what is the

Starting point is 00:16:53 difference in stock price between 2010 when he's writing this and now? And the stock is up more than 40 times from here. And so he's going to explain what happened in the next shareholder letter. But at the time I was reading that, I had no idea what was taking place. So I'm going to explain what happened in the next shareholder letter. But at the time I was reading that, I had no idea what was taking place. So I'm going to skip to the next year. And then I'm going to run over my own point. I just said like why he talks about why he writes the letters. He's like, as a rule, I use these letters to write about our business, not our stock. Something else that he talks about quite a deal, just like Warren and Charlie Munger talk about as well, is the need to only work with people you like, admire and and trust how a lot of people are out there rat poison you have to be very careful so mark talks about he's like i i want to if i can promote from within and this is why we nearly

Starting point is 00:17:33 always promote from within because mutual trust and loyalty take years to build and and conversely newly hired smart and our manipulative mercenaries can take years to identify and root out. Okay, so now we get to the 2012 shareholder letter. This is when I wrote in gigantic capital letters. This is when I knew I had a podcast to make. Up until this point, I was like, man, I don't know if there's enough information here. Like, is this going to be worth anybody's time? And then 2012, I'm like, okay, this is incredible. And this is when I just have a ton of highlights and notes. So I'm just gonna jump right into is incredible. And this is when I just have a ton of highlights and notes. So I'm just going to jump right into it.

Starting point is 00:18:06 Our long-term shareholders, our board, and our analysts all seem concerned about our ability to scale. I haven't spent a lot of time worrying about the issue except in response to their inquiries. We've evolved gradually over 18 years, and I don't feel like we are facing an impending paradigm shift. Nevertheless, when a number of smart, engaged constituents consistently harp on the same issue, it is worth investigating both their concerns and the mindset of those asking the questions. So this is what I meant about he's very open to changing his perspective. If you have better information, you have a better argument. He's not married to any of these ideas and he wants to make sure that he's always improving and getting the most optimal path forward. And so he's going to get into how to do his businesses grow because the issue is how can

Starting point is 00:18:51 we scale? We can't have, we have, you know, a hundred something software companies at this point. Can't get much bigger than this, right? What are we going to do? So he says, there's two components of our growth, organic and acquired. Organic growth is to my mind, the toughest management challenge in a software company, but it's potentially the most rewarding. The feedback And so before I go any further, I'm going to read the note that I left myself after I read this section because I think if I put this note at the beginning, it'll make sense what he's about to talk here. And I said, this part is incredible. It's about improving the financial performance of his company by understanding human nature and its likely pitfalls. Something as simple as tracking data and then holding one personal accountable. He's just writing about it in a nerdy, hard to parse way. So that's a note I left

Starting point is 00:19:39 myself to try to explain to myself what it is I'm reading. And so an engine for growth in normal companies, he's saying, listen, it's research and development and sales and marketing. So what we did is we separated our research and development and sales and marketing spending into two buckets, what he's going to call initiatives and then everything else. And so this is how he defines initiatives. Initiatives are significant long-term investments required to create new products or enter new markets. They usually take five to 10 years to reach cash flow break even. So these are large investments. It's a lot of money we're

Starting point is 00:20:10 putting out. And hopefully if they work out, we're not going to get to see that money back in five to 10 years. And a lot of these don't work out. So this is something you have to be very careful of. We felt that they should be both measured and treated differently than other than other expenditures. And a lot of the growth in initiatives comes from just human nature we want to over complicate things we want to say okay we need to add new features new software like new parts of our software we need to go into new markets which out without actually knowing if that's going to work or not and he says the ethos of software companies requires the regular launching of quote-unquote visionary new products by steely-eyed, tenacious developers, product managers, or founders.

Starting point is 00:20:49 Initiatives, so this constant outgrowth of humans constantly wanting to do more, whether that doing more is actually beneficial or not is uncertain, right? Initiatives grew to account for over half of our combined expenditures by 2005, which not coincidentally was the peak of our spending. So he's bringing this up because it's like, we're not going to be able to scale if we're not efficient with our money. And as we added more and more companies, they all happen to do very similar things. This got out of control. So now he's going to explain how he's going to wind up, how he wound up solving this problem. Remember, it is about improving the financial performance of your company by understanding human nature and its likely pitfalls. Even the best initiatives take more time and more investment than anticipated.

Starting point is 00:21:33 As the data came in, two things happened at the business level. We started doing a better job of managing initiatives and this spending, so research development, sales and marketing spending, decreased. So the first thing they did is they had to develop a system because we're barking on an initiative. We don't know if it's going to happen. So what is the assumption? So if you have your assumption, then you can test. If you have your hypothesis, you have your assumption, you can test to see if that assumption is wrong. And if you don't clearly define what that is, you might keep going way past and then you forget why you started this to begin with. So I'm going to skip over that part because that's really the summary. You have to find a way to what is the assumption of this new

Starting point is 00:22:13 initiative that you're doing? And how can you tell, like, what is the test you're going to do to know if that assumption is true or false? And the second, in my opinion, more important part is that they put one person in charge. He repeats this over and over again. You can't have a team. You can't disperse responsibility, put one person in charge. We created dedicated initiative champion positions. So an initiative was less likely to drag on with a low but perpetual burn rate, meaning we're just burning money. We're being inefficient with our capital, right? Under a part-time leader who didn't feel ultimately responsible and then he talks about what happened the most surprising adaptation was that the number of new initiatives proposed plummeted so before not one person was in charge we didn't we're kind of we weren't very specific

Starting point is 00:22:58 on what we were hoping to actually achieve with this new initiative so it kind of just grew just what humans do right but once you say okay what, what is the assumption you're testing? How do we know if that's true or false? Let's design an experiment and we'll put one person in charge. Guess what? The number of new initiatives dropped, which indicates that we were just being wasteful because initiatives are so expensive. Remember, they were half of all of our spending. Now that number is way down. We're a lot more efficient. And then he talks about how they figured this out. We did not get to this point with central edicts or grand plans. We just had a hunch that our internal ventures could be managed better and we started measuring them. The people involved in the initiatives generated the data

Starting point is 00:23:36 and with measurement came adjustment and adaptation. It took six years but we have fundamentally changed the mental models of a generation of our managers and employees. So then he continues talking about other ways to grow a company, other ways to scale a company. He talks about, hey, the other way we grow is via acquisitions. And so he talks about who he buys these companies from. This is exactly what Warren Buffett does in shareholder letters where he says, hey, I buy businesses. There's a ton of other people that buy businesses. This is why all money is not created equal. This is why you'd want to sell me your company as opposed to my competitors.

Starting point is 00:24:10 So Mark's going to do something very similar here. Our favorite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests a better part of a lifetime building a business, a long-term orientation tends to permeate all aspects of the enterprise. Employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated products. Founder businesses tend to be a very good cultural fit with Constellation. And most of the ones that we buy operate as standalone business units managed by their existing managers under our umbrella.

Starting point is 00:24:41 So that's, again, very, very Buffett-like, right? We track many thousands of these acquisition prospects and try to regularly let their owners know that we'd love the chance to become the permanent owners of their business when the time is right for them. And he's saying he's also about to ride this gigantic demographic wave. This is something that now he's talking about this. We're in still 2012. This is talked about. I'm hearing this a lot more like top of mind. I hear a lot of other people bring this up now is my point. There is a demographic element to the supply of these acquisitions. Most of these businesses came into being with the advent of mini and micro computers, and many of their founders are baby boomers who are now thinking about retirement.

Starting point is 00:25:22 So that's one distribution channel for Mark. Now he's going to talk about this other distribution channel for him. The most lucrative acquisitions for us have been distressed assets. Sometimes large corporations convince themselves that software businesses on the periphery of their industry will be good acquisitions. Rarely do the anticipated synergies accrue. And frequently, the cultural clashes are fierce. So the corporate parent may eventually choose to sell the acquired software business. So founder sold a software business to a larger company. Larger company had its own weird desires and reasons and rationales for doing that. There's no synergy. So now that asset's still valuable, but now it's been

Starting point is 00:26:01 distressed. That large company is just like, all right, I just want to get rid of it. Mark's like, okay, cool. I'll take it off your hands and I'll optimize it. And he says, there's a time that this usually occurs. Most of our, the most attractive acquisitions from corporate, large corporations have happened during recessions. And towards the end of this letter, this is the first time I realized, oh, okay, he's completely open to new information and willing to change his mind. The note I left myself on this section is this is remarkable. Usually you only get this type of insight into a founder's perspective on their business in private. He's usually not going to write about this in public. He says, from time to time, we flirt with a fundamental change. I was recently in the UK where a couple of very large

Starting point is 00:26:41 public sector vertical market software conglomerates are for sale. The whisper prices, so there's not a price on them yet, but people are telling them, you know, on the low, you could probably get it for this. The whisper prices are ones we could just about stomach if we were financing the acquisitions on a standalone basis, like PE firms that compete for these assets. My sense is that we would be better owners of these assets and would generate better long-term performance for them than the PE, private equity companies, that are trying to buy them.

Starting point is 00:27:12 Up until this point, he wanted to do these acquisitions from cashflow. And he's saying, well, these things are too big. Usually, you know, we're sub 3 million, right around there. These are big, but they're still opportunities. And so he's like, maybe in the case, I would take on debt or some kind of other financial instrument or more leverage, essentially, to do this. Our current bank facilities do not allow us to make acquisitions, which incorporate standalone financing. And hence, this opportunity to make substantial acquisitions on attractive assets that are close to our core competence is moot but intriguing.

Starting point is 00:27:46 So then this is where he gets into like this, I would call it like a small, beautiful philosophy. Because at this point, the board, his board is worried about the growing complexity of consolation. And at this point, they own 125 businesses. And so this is Marx's analysis. Like, is this concern valid or not? And he says, one early observation is that our business units rarely get large. The biggest is 307 employees, and the average business we own currently only has 44 employees. Two-thirds of our employees are working in businesses with less than 100 employees. When we did a linear regression

Starting point is 00:28:23 analysis of performance, the data suggested that the size and performance of our business units are almost totally unrelated. This suggests that the size and performance of our business units, the size and performance of our business units are almost totally unrelated. I believe that these business units are small for a reason,

Starting point is 00:28:42 that the advantages of being agile and tight far outweigh economies of scale. I am not a proponent of handling our quote-unquote complexity problem by creating a bunch of 400 employee businesses to replace our 40 employee businesses. I'm looking for ways of achieving scale elsewhere. Then he goes back to this idea, it's like, how can I increase the amount of acquisitions we have? And he says, debt is cheap right now, so it's pretty tempting to use it. Unfortunately, it has a nasty habit of going away when you need it most. Personally, I would use significant amounts of debt to finance our growth if it were long-term, non-callable, and the interest payments could be deferred for short periods we have demonstrated

Starting point is 00:29:25 the ability to generate good returns on incremental capital over the long haul unfortunately investment bankers tell me that this sort of debt doesn't exist so then we fast forward one year he has found a way to to get about 500 million dollars in debt really the way to think about this is the opportunities were there. So he wants to act right now. So he's like, our cash flow is growing really fast, but it was still insufficient to finance the acquisitions that we made. So we resorted to using increasing amounts of bank debt. But what's interesting, he's talking about is like, this isn't a perfect strategy. We had $485 million outstanding on our debt. We continue to seek longer term capital to diffuse the fundamental

Starting point is 00:30:06 mismatch inherent in buying permanent assets with short term debt. So he's like this. We're doing it now, but this is not something that I want to do forever. And then towards the end of this letter, he has one line that really speaks to the benefit of conglomerates. And this is going to remind me of something that Warren writes about in his shareholder letters. And so he says, it is clear that acquisitions have added tremendous shareholder value over the years, particularly during times of economic crisis or recession. So Warren says very similar about why, like what are some of the benefits of being a conglomerate? So I'm going to read this. This is from the essays of Warren Buffett, which is episode 227, if you haven't listened to it yet. And he says, conglomerates such as Berkshire is perfectly positioned to allocate capital rationally and at a minimal cost.

Starting point is 00:30:54 Our structural advantages are formidable. We can, without incurring taxes or much in the way of other costs, move huge sums of money from businesses that have limited opportunities for incremental investment to other sectors with greater promise. So sometimes a business is producing a lot of cash flow, doesn't have anywhere to invest that money. In a conglomerate such as Berkshire or CSI or Teledyn or any of these other situations, they could find a better home for that money. Moreover, we are free of historical biases created by lifelong association within a given industry and are not

Starting point is 00:31:25 subject to pressures from colleagues that have a vested interest in maintaining the status quo. Another major advantage that we possess is the ability to buy pieces of wonderful businesses, also known as common stocks. That's not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful. A broad range of options sharpens decision making. That is a fantastic statement by Buffett. The gains we realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capability. So that's interesting. So we have these businesses that are off cash flow.

Starting point is 00:32:05 Sometimes the best use of that cash is to buy common stocks. Those common stocks have turned out to be such fantastic investments for us that their gains have in turn made it possible to create large acquisitions that we didn't have the money to do beforehand. So it's like this virtuous cycle, right? In effect, the world is Berkshire's oyster, a world offering us a range of opportunities far beyond those realistically open to most companies. On top of that, we can profitably scale to a far larger size than many businesses that are

Starting point is 00:32:39 constrained by the limited potential of a single industry in which they operate. And then what I also loved about reading Mark's letters is he sometimes recommends books, which I thought was very interesting. So this is the first example of that. He says, currently, I'm shamelessly flogging Danny Kahneman's Thinking Fast and Slow. So all the, and anytime I mention a book on the podcast, I always leave the link in the show notes to make sure you look out for that. Same here.

Starting point is 00:33:03 I read this book a long time ago too. I'm shamelessly flogging Danny Kahneman's Thinking Fast and Slow. His book is about a life, actually two, because Danny wrote it with his partner Amos. Well spent. He tells the tale of his intellectual journey via a series of behavioral economic experiments. He's helped me appreciate the efficiency, speed, and inherent conceit of intuitive judgment and its infrequent but often abject failures that's just good writing on on mark's part understanding the major findings in this in behavioral economics provides profound insights into investing and managing and this book is the most pleasant way i've found to acquire that knowledge so now we go to 2014 this was interesting last year i asked the board to reduce my salary to zero.

Starting point is 00:33:48 CSI had a great year. So despite these modifications, my total compensation actually increased. This year, I'll take no salary, no incentive compensation, and I am no longer charging any expenses to the company. I have been president of CSI for its first 20 years. I have waived all compensation because I don't want to work as hard in the future as I did during the last 20 years. I was totally not expecting this when I got to this part too, but it makes sense when he explains his thinking here. So he says, cutting my compensation will allow me to lead a more balanced life with a less oppressive sense of personal obligation. I'm paying my own expenses for a different reason. I've traditionally traveled on economy tickets

Starting point is 00:34:25 and stayed at modest hotels. A large part of his job is travel. I've traditionally traveled on economy tickets and stayed at modest hotels because I wasn't happy freeloading on CSI shareholders, and I wanted to set a good example for the thousands of CSI employees who travel every month. I'm getting older and wealthier, and I find that I'm willing to trade more of my own cash for comfort, convenience, and speed. So I'm afraid you'll mostly see me in the front of the plane from here on out. I love what I'm doing and don't want to stop unless my health deteriorates or the board figures it's time for me to go. I recognize that some of our directors, shareholders, and employees have or are going to have misgivings about this arrangement.

Starting point is 00:35:07 I'm still planning to do the work that I've always done, acquisitions, monitoring, best practice development, investor relations, and financing. I'm just not going to do the weekends, all-nighters, and a constant grind of 60-hour-plus weeks that have characterized my earlier career. And part of his ability to cut back is the fact that he's actually built an organization to last, one that can actually outlive and will outlive him. Keep in mind that CSI has an unconventional organizational structure, and we seem to have prospered to date without a lot of centralized command and control. While I may not be traveling as much as I did before, nor putting in as many hours, CSI has lots of seasoned and accomplished managers at the operating group level who have become far better coaches, culture bearers, and hypothesis generators than I ever was.

Starting point is 00:35:59 And then he goes into another benefit of this arrangement, not taking a salary. And he says, one of the reasons of this compensation change is that I get to sidestep the agent principal problem. My compensation for being president is now tied solely to my current ownership of CSI shares. In essence, I'm your partner, not your employee. I like the feel of the partner relationship a whole lot better. And then he goes back into this idea, we're growing bigger and bigger, so we have more pressure to centralize. And just like Henry Singleton, he wants the businesses to be as small as possible. And so he says, shareholders sometimes ask, why don't we pursue economies of scale by centralizing functions,

Starting point is 00:36:42 like research and development or sales and marketing? My personal preference is to instead focus on keeping our businesses small and the majority of the decision making down at the business level. Partly this is a function of my experience with small high performance teams when I was a venture capitalist. So that was his job as a venture capitalist before he founded CSI. Really what he's saying here is something that you and I have discussed over and over again, that it's just a lot better to trust in small groups of smart people. That's where all the magic happens. So it says, partly, this is a function of my experience with small, high performance teams when I was a venture capitalist. And partly, it is a function of seeing that most vertical markets have several viable competitors who exhibit little correlation between their

Starting point is 00:37:22 profitability and scale. So he brings that up again. Just because you're getting bigger, just because you have more headcount, does not mean you're actually improving your business's performance. So again, trust in small groups of small people. And then he goes into what you should do if you also hold this belief. There's a number of implications if you share my view. We should, number one, divide our largest business units into smaller, more focused business units unless there's an overwhelmingly obvious reason to keep them whole.

Starting point is 00:37:54 Number two, operate the majority of the businesses that we acquire as separate units rather than merging them with existing businesses that we own. And number three, drive down cost at the head office and operating group level. And then this next part is going to be several sentences. I want you to bear with me because I really do think this is a very clear description of what he's building, the advantages the strategy provides, and why he's going to be hard to compete with over the long term. Keep in mind, we are now, we're in 2014. So this is still quite old, or several years ago. Not quite old, that's not the right way to put it.

Starting point is 00:38:29 Several years ago. So let me just read this to you. I find that some of our shareholders confuse our strategy with that of our business units. So Constellation Software overall with some of our business units. While there are terrific moats around our individual business units, the barrier to starting a conglomerate of VMS, which is what he's doing, is pretty much a checkbook and a telephone. So low barriers to entry, tons of people have phones, tons of people call businesses saying they want to buy them, and tons of people can raise money to buy businesses.

Starting point is 00:39:01 So it says there's terrific moats around individual business units, but the actual barrier to jumping in and trying to copy what we're doing is kind of low. So we got to find a way to maintain our long-term competitive advantage. Nevertheless, CSI does have a compelling asset that is difficult to both replicate and maintain. We have 199 separately tracked business units and an open collegial and analytical culture. This provides us with a large group of businesses on which to test hypothesis, a ready source of ideas to test, and a receptive audience who can benefit from their application. So those are the business owners running the individual business. More quickly and cheaply than any company that I know, we can figure out if

Starting point is 00:39:45 a new business process works. This sort of ad hoc experimentation doesn't require enormous systems or the peddling of a new dogma to the unreceptive. It requires curious managers at a few dozen business units and a couple of clever analysts to plausibly test if a process works. Once a new best practice starts working within CSI, wide access to benchmarking information tends to rapidly breed emulation. So we have 199 business units. We can run a test in 5, 10, 6, 24, whatever it is. We find it works.

Starting point is 00:40:22 We can spread it throughout the entire company. And spreading best business practices makes those businesses better. The longer it goes, the more businesses we have, the stronger they get over the time. That's nice. You have a checkbook. It's nice. You have a phone call, but I'm way too far ahead. You'll never catch me. That's essentially what he's saying. We have found a few other examples of high performance conglomerates, which he refers to as HPCs, but I'll always, I hate acronyms and stuff like that. So I'll always say it out. We have found a few other examples of high performance conglomerates built around the idea of continuously refining their business processes and then driving ever more acquired businesses up their business process learning curve as quickly as possible. Listen, I liked reading his letters.

Starting point is 00:41:00 Sometimes I thought they'd be more valuable if he kind of dumbed it down. I understand that's not his goal, but if you think about what kind of customer acquisition channel and distribution channel that Buffett's your hotel letters have been because he can talk to you like you're in like fifth grade Mark is obviously very brilliant very smart but sometimes it's like whoa I gotta I'm trying to translate exactly what you're saying here I've had to reread certain sections a bunch of times I don't think he really necessarily cares about that or who actually, I don't, I don't know if he cares about that or not, but all I, there's a couple of separate notes as I'm reading this about, Hey, you really like try to reword this and more people would read them. And again, maybe he doesn't want more people reading

Starting point is 00:41:37 them. I don't know. And so even though the wording is a little difficult there, I think the idea is pretty simple to understand. We're going to test, we're going to experiment. All the stuff that we have, all these experiments that we're running across these hundreds of businesses that we own, the good one, the good ideas that we find through experimentation, they're most likely counterintuitive. So other people, unless they're running experiments, aren't going to arrive at those same conclusions. And then we're just going to spread them around. It's very similar to why did the founder of Kinko's, Paul Orfala, that's founders number 181, if you haven't listened to it, he had this weird decentralized structure for all the different Kinko stores. He spent no time in the office. All he would do is travel around to different stores and he wouldn't rule by edict. So you had a lot of leeway as a manager of an individual Kinko's. And he was asked, like, why aren't you saying. I'm going to spread around the other company. I'm going to share the idea with the other stores, right?

Starting point is 00:42:26 But I'm not going to make them do it. And he was asked by one of his employees, like, why aren't you making them do it? He's like, because if I make them do it, that was the best it will ever be. And so he kind of did that. What Mark is talking about here, doing it across a bunch of different businesses

Starting point is 00:42:39 and different industries, you could also do that within your own company. Let's say you had stores or divisions or whatever case in Kikos, you probably had 500 different stores, whatever the number was. And so Paul's traveling around getting all the ideas. Instead, there's a line in that book that's fantastic because I think it's descriptive of what I'm trying to do with founders. Except instead of going around to different Kikos stores, I'm going around to the greatest entrepreneurs to ever live.

Starting point is 00:42:58 And he says you had to remember he's been picking up the best ideas from all around the country. So that's what Paul was doing at Kinko's. That is what Mark is doing now. He's picking up all the best ideas across all the hundreds of businesses he owns. And then I'm trying to do the same thing for you across, you know, whatever. I'll get to 1,000, 2,000, 3,000 different entrepreneurs throughout history. And finally, he ends this year with another book recommendation. I'll leave the link down below. He says, the evolution of cooperation by Robert Axelrod has provided me with models for thinking about a number of business problems.

Starting point is 00:43:31 Okay, so let's move on to 2015. This is another smart idea. And so what Mark's going to do is they put, he says, each quarter, we study an admirable company, and we discuss it with our operating group managers and board members. So this is the entire, I think this year, if I'm not mistaken, this 2015 shareholder letter, is he goes through all the high-performance conglomerates. I think there's about a dozen. I think he said he studied. I can't remember the exact number. But basically he's saying, hey, let's look at the cream of the crop. Let's analyze what they're doing and why they're doing it and see if we can use any of their ideas.

Starting point is 00:44:02 That's essentially what's happening. We focus on high-performance conglomerates that have demonstrated at least a decade of superior returns. And why is he doing that? We study the high-performance conglomerates because they help us understand what CSI does well, where we might improve, and what alternatives we could pursue. And he says we set a high bar on purpose. Keep in mind that we are comparing CSI to a group of wonderful companies. Over the last decade, if you had an equally weighted portfolio of the shares of these high-performance conglomerates, you would have more than doubled the performance of the S&P 500.

Starting point is 00:44:35 So I'm not going to go over every single one. I do want to pull out one of these. I'm going to read this book that he recommends too. We have reviewed one of our perennial favorite high-performance conglomerates this quarter. It's called Jack Henry & Associates. The company's values are those to which we aspire, and their multi-decade performance is remarkable. I encourage you to familiarize yourself with J-K-H-Y, which is Jack Henry & Associates. There's also a lovely company history, You Don't Know Jack or Jerry is the name of the book, that was written by a retired executive. The book covers the founding of the company all the way from the founding of the company all the way up to 2007.

Starting point is 00:45:12 It provides many firsthand accounts by employees, customers, competitors, and partners about the business practices, strategy, and culture of the company. Then he goes back to what he's learning from sitting in all these different companies. He's realizing, okay, not only what do they do smart, like what's some of the intelligence decisions they make, but what are the mistakes they made that we can avoid? And so he's saying, like, how do we avoid the pressure for us to centralize? And so he says, only one other high-performing conglomerate has followed a strategy of buying hundreds of small businesses and managing them autonomously. That's exactly what he's doing. They eventually caved to centralization. My hunch is that it takes an unusually trusting culture and a long-term investment horizon to support a multitude of small businesses and their entrepreneurial leaders.

Starting point is 00:45:56 If trust falters across our businesses, they can be choked by bureaucracy. So we have to have a high trust culture. If short-term results are paramount, as opposed to our long-term focus, the siren song of consolidation synergies are powerful. We continue to believe, however, that autonomy and responsibility attract and motivate the best managers and employees. And then he also talks about that most of these high-performing conglomerates are not in software, and that software is a very strange business. And this is an talks about that most of these high-performing conglomerates are not in software and that software is a very strange business.

Starting point is 00:46:26 And that's an example of that. One of the problems with growing asset-light businesses, software businesses, is that historical invested capital required to purchase the business becomes increasingly irrelevant over time. These are good problems to have, by the way, what he's about to describe to us. We have a number of businesses where current earnings now exceed their original purchase price. If these businesses have achieved that growth organically, they have also likely reduced working capital significantly, perhaps driving the net purchase price below zero, meaning we got all the money back. And hence, the return on investment capital back, and hence the return on investment capital, it's pushed the return on investment capital to infinity. That's such a bizarre sentence. These sorts of businesses defy conventional financial statement measurement. Then he gives us two more book recommendations to end this letter. The first one is One Man's

Starting point is 00:47:22 Medicine, an autobiography by Professor Archie Cochran and another book that Archie wrote called Effectiveness and Efficiency, which is random reflection on health services. But he says the first book

Starting point is 00:47:32 is a moving, idiosyncratic, and amusing autobiography of a brilliant and erudite outsider that makes you wish you had known the man firsthand. Makes me want to read that book.

Starting point is 00:47:43 And I might. If I read it, I'll obviously turn it into an episode for Founders. The second is a stinging critique of well-meaning but entrenched medical establishment for their ineffective and dangerous medical practices. But what's fascinating, the reason I'm bringing this to your attention

Starting point is 00:47:55 is because he draws the principles from the book and realizes he sees the same behavior in business. Archie's observations regarding medical practice and doctors struck me as applying equally to business practices and managers. The asymmetric effectiveness of most medical treatments Very smart that he drew this parallel. And so he says, at CSI, we spend time on non-randomized observational studies trying to spot business practices that actually add value rather than just adding overhead. And then we get to my absolute favorite part of all the letters. This is where he just lays out his philosophy about why he's doing what he's doing. Our strategy is to be a good owner of hundreds and perhaps someday thousands of growing, autonomous, small businesses that generate high returns on capital.

Starting point is 00:48:49 Our strategy is unusual. Most CEOs of public companies would rather run a single big business, perhaps two or three big businesses, but rarely 200 businesses. We recognize that economies of scale, centralized management, and world-class talent competing in large and growing markets can be a great business building formula, but it isn't what we do. So essentially he's saying, like this is the note I left myself here is this is great. We understand that game, but we want to play a different one. We seek out vertical market software businesses where motivated small teams composed of good people can produce superior results in tiny markets. That is our game, right? What we offer our business managers is autonomy, an environment that supports them in mastering

Starting point is 00:49:37 vertical market software management skills, and the chance to build an enduring and competent team in a quote unquote human scale business. And then he goes into the benefits that human scale as opposed to gigantic centralized companies have, right? At human scale companies, all the employees know each other. And if a team member isn't trusted and pulling their weight, they tend to get weeded out. If employees are talented, they can be quirky as long as they are working for the greater good of the business. Priorities are clear. Systems have not had time to metastasize. Rules are few. Trust and communication are high, and focus tends to be on how to increase the size of the pie, not how the pie gets divided. That is how I remember my favorite venture investments

Starting point is 00:50:31 when I was a venture capitalist, his job before this, and is how I remember many of the early CSI acquisitions. Then he continues on this theme, describing why small is beautiful. The larger a business gets, the more difficult it becomes to manage, and the more policies, procedures, systems, rules, and regulations are generated to handle that growing complexity. Talented people get frustrated. Innovation suffers, and the focus shifts from customers and markets to internal communication, cost control, and rule enforcement. The quirky people, the quirky but talented people, rarely survive in this environment. A huge body of academic research confirms that

Starting point is 00:51:13 complexity and coordination effort increases at a much faster rate than headcount in a growing organization. And then he talks about why these gigantic organizations are actually incompatible with human nature. No one wants to admit that they've hit their limit. Some business managers lack the humility, some lack the courage, and most lack the time for reflection to notice that their task is getting too large

Starting point is 00:51:39 and the sacrifices are going to be too great. And so his solution is going to echo what Henry Singleton discovered. If a large business is not generating the organic growth that we think it that the original business manager runs a large piece of the original business and spins off a new business unit run by one of his or her protégés. This dividing of larger business units into smaller units is rare, but it is not unknown. One of the high-performing conglomerates that we studied was Illinois Tool Works, which is ITW. I don't think I've heard of this before. It has hundreds of businesses. We began following the company from

Starting point is 00:52:30 afar in 2005. The most relevant period in ITW's history for CSI was the tenure of John Nichols. Nichols began consulting for ITW in 1979, and it appears he was the primary author of its decentralization strategy. He was CEO of the company as it went from $369 million in revenue to $4.2 billion, and he did that in about 14 years. Prior to Nichols' tenure, ITW had acquired only three businesses. During his tenure, ITW aggressively acquired and often split the larger acquisitions into smaller businesses. ITW had 365 separate operating units by 1996

Starting point is 00:53:16 when Nichols retired. And he talks about the process of studying the company. I'm sorry I did not reach out to some of the ITW employees and ex-employees until 2015. So he's on his radar starting in 2005. It took him 10 years to realize, hey, I need to talk to some of these people. When I did talk with one of the senior managers, he said, there's some quotes from these discussions that they're having. Number one, something wonderful happens when you spin off a new business unit. With a clean sheet of paper, the leader only takes And then there's two other pieces of advice that from this conversation he wrote down

Starting point is 00:54:01 and he wanted to remember. Number one, don't share sales, R&D, HR, etc. Because the accountants never get the allocations right and the business units always treat the allocated costs as outside their control. And number two, and the most important, when you get big, you lose entrepreneurship. And one of the last things I want to share with you from the letters, this is too good not to include, it is the advice that he would give his 35 or 40 year old self. So this is a perspective of somebody who's in their mid-60s, multi-billionaire that's developed an amazing, wonderful business. And he still, what's remarkable is he still thinks that VMS

Starting point is 00:54:41 is the business to be in today, right? So he says, If I were advising my 35 or 40-year-old self on where to go from here, I would tell him to stay put. Become a master craftsman in the art of managing your VMS business. It is the most satisfying job and will generate more than enough wealth for you to live very comfortably and provide for your family. And I'll close with these four quotes that he leaves at the very end of this letter. We should no more trust executives who rely solely on their experience than we should trust doctors who ignore clinical trials.

Starting point is 00:55:20 Science is organized skepticism. Too much of business is disorganized optimism. And finally and most importantly, you can't be normal and expect abnormal results. And that is where I'll leave it. I'll leave a link down below. You can read all the shareholder letters. They're available for free online. And I'll also leave a link in case you want to give a family friend or co-worker a gift subscription to Founders. As always, I appreciate the support and I'll talk to you again soon.

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Founders - #246 Mark Leonard's Shareholder Letters

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