Investment Ideas & Company ResearchInvestment PhilosophyInvestor Letters

Returns on Capital and an Investment Idea

A couple years back, I wrote a series on the topic of returns on capital (ROIC) and how significant its impact is on the long-term value of a business. As a long-term shareholder of a business, your ultimate investment result will be determined by the quality of that business over time. One way to measure quality is to figure out the rate of return that the company achieves on its own internal investments (as well as what that company does with the excess cash flow that it can’t reinvest).

If your plan is to own stock in a company over a longer period of time (as opposed to buying stock with plans to sell it to someone else next quarter or next year), then it becomes imperative to estimate the amount of capital a business requires, the share of its earnings that the company can retain and reinvest back into the business, and the approximate rate of return that those investments will achieve going forward.

Simply put, the incremental return on capital (i.e. the ROIC going forward) is really what you want to know if you are interested in approximating a company’s long-term earning power.

Some of the best writing on the subject of ROIC was done by my friend Connor Leonard of Investors Management Corporation (IMC). Connor is a smart investor and an original thinker. He’s one of the few people that I use as a “sounding board” to bounce around various investment ideas and concepts.

Reinvestment Moat

Last year, Connor wrote two pieces called Reinvestment Moats vs. Legacy Moats and Capital-Light Compounders. They are both well-written, clearly laid out posts that do a nice job of explaining why returns on capital are important to long-term investment results.

Over the last year Connor expanded on these concepts in various writings and presentations, a couple of which we are including below. Connor recently presented at ValueX Vail where he outlined his investment thesis on zooplus AG, Europe’s leading online retailer of pet products and a potential Reinvestment Moat. Additionally, Connor puts together investing commentary once a year, which privately-held IMC has allowed Connor to share with Base Hit Investing readers.

Here is Connor’s presentation on zooplus AG:

Download (PDF, 5.81MB)

Connor Leonard’s investment commentary:

Download (PDF, 486KB)

8 thoughts on “Returns on Capital and an Investment Idea

  1. I read through Connor’s zooplus report recently and am a big fan of his thought process in general… but I just can’t get confident zooplus should be advantaged against Amazon long-term.

    * I’m neither sure (A) that zooplus’ average prices will remain 8%-17% lower than Amazon or (B) that being ~ 10% lower even matters much once your customers begin signing up for prime. On this second point, Amazon is aggressively pushing prime membership in Europe (, and once customers sign up for prime, there is a strong tendency (myself included) to not bother shopping around the internet over small price differences.

    * I’ve heard some say Amazon is just not set up to ship large items. My order history disproves this thoroughly.

    * It is true has competed well against Amazon in the US… but they don’t (and may never) actually make any money by most accounts.

    My other issue with the presentation was bringing up the Costco model (of passing windfall profits back to customers) on one page and then using a 5%-10% EBIT margin several pages later on the valuation page. Costco operates around 3% EBIT. If we used a 2% net income margin long-term for zooplus (~ 40% effective tax rate) and assume an ambitious 15% per year revenue growth rate the next ten years (growth expected at 18% this year and should trend down over time), I’m not sure there’s enough upside at today’s prices weighted against the downside of competing with Amazon… unless one starts assuming a sale in the interim which is of course possible.

    1. I currently don’t own Zooplus, but I think it’s an interesting business. It’s on my watchlist and I’m spending time learning more about it.

  2. ROIC or ROE with manageable leverage is one my key performance indicators when picking stocks. Sometimes I replace earnings with freecash flows which also does pretty well. Thanks for amazing post as always!

  3. Interesting post! Looks like very good execution record despite of continued deflated price and AZN’s competition. I have some questions – how do you frame the TAM and how much offline market can be addressed by online. I wonder if there is any consumption behavior inertia that the customers have. And it seems a bit odd to me the slide implies zooplus’s topline growth from 10-16 has trailed behind the market – my calculation shows 35ish vs 40-50ish% (excluding the price impacts it would have been lower too). As for the comparison to COST, I think there could be additional margin upside for Z simply because one relies on asset heavy expansion model, while the other lighter. Given the lighter cost structure, to what extent of op leverage Z can pull would be hinged upon its ability to scale up and exploit logistics / headquarter efficiency

  4. The first rule of investing is never compete with Amazon.

    I mean, it is honestly insane to compete with Amazon. Consider what this actually involves.

    Consider what happened to the vast majority of businesses that tried to compete with Amazon. It turns out that most businesses that tried to compete with Amazon lacked some of Amazon’s advantages. These advantages include nearly zero cost of capital, low taxes, high ephemeralization, investor willingness to put up with approximately zero profit margins for decades, obsession with efficiency, customer experience, and innovation, incredible supply chain expertise, incredibly low compute cost, and being full of underpaid MIT Ph.D.s that work long hours to just absolutely crush every challenge (and the competition).

    All the Amazon competitors really just found themselves in a 15 foot high jumping competition with a 40 foot tall giant.

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