Idea Brunch with Roger Fan of RF Capital

Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Roger Fan!

Roger is currently the chief investment officer of RF Capital, an LA-based fund he founded in 2017. Before launching RF Capital, Roger earned his J.D. from the Texas Tech University School of Law. Roger likes to invest in “obscure, undervalued companies globally across all sectors with an emphasis on micro-cap companies.”

(Editor’s Note: Sunday’s Idea Brunch is looking to interview more talented off-the-beaten-path investors like Roger. If you know of someone magical, please email edwin@585research.com or hit reply!)

Roger, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch RF Capital?

First, thank you for the invite. Sunday’s Idea Brunch is a great interview series. The list of fund managers that you have interviewed previously is quite impressive.

So I decided to launch RF Capital because friends and family kept asking me what I wanted to do after law school. Up until that point, I was managing my family’s money and my own with great success. I had also been providing friends with investment ideas and they knew about the returns that I was generating.

Initially, I planned on working as a hedge fund analyst after graduation. However, my friends and family persuaded me to go out on my own. They kept following up with me to see if I’d be willing to manage their money as a professional investor. And they were quite persistent! Without their encouragement, I would’ve taken a job offer as an analyst somewhere. Since I already had many years of living expenses saved up and a private track record of strong returns,

I decided to take a leap of faith and launch the firm.

I wouldn’t necessarily recommend that to young professionals today, but that is the path I took. It helps when you are only 28 years old, young, and don’t know any better! However, I’m in the seat that I’ve always wanted to be in now, so it all worked out.    

How did studying to be a lawyer and doctor influence you as an investor?

Going to law school was one of the best decisions I ever made. I know that many professionals disregard advanced education and say it’s useless, but I attribute my success to law school. The skillset that you gain from law school is directly transferable to investing. For example, issue spotting is a crucial skill in law, and that is the way I read and process information today. Issues pop up in my head left and right no matter what I’m reading – financial filings, transcripts, proxies, press releases, newspapers, etc. You can’t read primary information sources passively. You have to be active, identify issues as you read, and take notes on the computer or legal pad.

I also became a better writer in law school. I don’t consider myself an excellent writer, but I improved by leaps and bounds during my time there. All the memos, briefs, and exam essays that I had to write provided me with plenty of practice and volume. You learned to write persuasively and efficiently if you wanted to get good grades and/or win the competitions!

Many investors don’t realize it, but writing is an important part of the investment business. Strong writing skills help you write great investor letters, research memos, and emails to management teams, investors, employees, etc. Writing is applicable to investing no matter what type of role you are in. On the investing side, portfolio managers and analysts have to write in some way shape or form. Similarly, founders and COO-type people have to communicate with prospects and their investor base.

Crafting persuasive arguments is another skill that is a byproduct of all the reading, researching, and writing that you do in law. You not only have to create a strong argument for why you should win, but you also have to address the other side of the table. You have to be able to anticipate what opposing counsel is going to say, and you have to be able to negate their arguments. That is your job as a lawyer – to persuade the judge and the jury if you’re in trial.

With investing, that means thinking extensively about why you should be long or short a company. Then depending on which side of the trade you’re on, you have to think about the opposing side. More importantly, you have to be able to figure out what exactly it is that you know more than the market. Remember, when you buy or sell short a stock, sophisticated market participants are on the other side of the trade. You always have to ask yourself if you’re the patsy at the table.

Taking a step back even further, my time as a premed in college also helped tremendously. There, my life was all about math, sciences, and economics. With those subjects, volume, and precision were needed. You had to work and solve a lot of questions and problems to be proficient. And you had to be precise. There are only so many ways you can solve a math or organic chemistry problem. There’s no flexibility like there is in law. In law, you can argue something both ways. And if you don’t understand the black letter law, you can “BS” your way through the analysis and manipulate the facts to arrive at a conclusion. In the math and sciences, that kind of approach doesn’t work. Oftentimes, there’s only a handful of ways to solve a problem and there’s only one answer.

The research-intensive science classes also provided me with plenty of exposure to the scientific method. The scientific method is actually a lot like law and investing. You start with a hypothesis and you work extremely hard to disprove it. It’s a lot like crafting a legal argument. So again, there’s a lot of overlap in terms of process between math, science, law, and investing.

And from all the internships and volunteer work that I did, I learned how to communicate with people and how to be personable. All the doctors, nurses, and techs that I worked with were all amazing. They were so great with patients, and I learned from them how to interact with others. I didn’t learn as much of this in law, but the human element is certainly present. You have to be personable and an effective communicator when dealing with clients, judges, opposing counsel, witnesses, experts, etc.

I also learned the importance of speed and flexible thinking during those internships. I did several rotations in the Emergency Room departments. As one can imagine, the nurses/doctors had to be quick when diagnosing and treating patients. In the ER and the OR, speed and accuracy are crucial. In the investment business, it’s never on that level of intensity. But in the hospital, it quite literally is a matter of life and death. I’ve seen table deaths in the operating room and many people who died in the ER. Those experiences really reinforced the importance of speed and accuracy. That’s why as an investor, I do everything quickly but accurately.

In short, I was blessed to have had such a multi-disciplinary education. As Charlie Munger put it, it provided me with a lollapalooza effect in life and insights that I wouldn’t have gained otherwise. I didn’t study anything at the PhD level, but having exposure to a broad range of disciplines from math and sciences to economics, accounting, and law certainly influenced the investor that I am today.

On your website, you stress you look for “aligned management teams.” What exactly does that mean? Could you please share some examples of egregiously misaligned or extremely well-aligned management teams you’ve seen?

An aligned management team is when key executives like the chairman, CEO, and CFO own a significant amount of stock. Additionally, their compensation packages aren’t egregious. The way they manage the company via capital allocation is also very telling of whether they’re aligned with shareholders or not. If you just follow the trail of transactions from dividends and buybacks to acquisitions and reinvestments, you can figure out quickly if the management team is doing what’s best for shareholders. Sometimes, it’s best to take a step back and pretend you are the Chairman and/or CEO. Then review all the deals, transactions, and capital allocation decisions as if you owned 100% of the company. Pretend that you are the founder and involved in the day-to-day operations of the company.

I won’t identify any misaligned management teams in particular, but you really do see some ridiculous things going on when you turn over a lot of rocks. Some of the salaries and stock option packages I’ve seen are astronomically high - relative to both the peer group, the industry, and the company’s revenues and earnings. I have no problem with talent being well compensated. However, the dollars allocated for compensation must match the skill level and the company’s finances.

I’ve also seen bone-headed transactions that have deterred me from making an investment. As I stated before, I like to detach myself from the investor hat and pretend like I’m the owner operator of the business. And a lot of acquisitions, buybacks, etc. just don’t make any sense sometimes. When you think critically about capital allocation decisions, sometimes you just arrive at the conclusion that management is just lighting cash on fire.

Related party transactions are another thing to watch out for. If you read the footnotes, sometimes you’ll see ridiculous related party transactions. And you can just tell that management is enriching themselves through the company. What’s worse is when you ask them directly about it and they’ll sidestep it or give you an answer that is so unsatisfactory that you can tell they are outright liars.

Analyzing boards and management teams can actually be quite a process. It certainly makes for a deep conversation - especially with peer portfolio managers. However, I try not to place too much of an emphasis on management teams even though it’s one of the key criteria. I just place the analysis lower on my priorities list.

I’ve found that I’m an optimistic person in general and will give people the benefit of the doubt based on first impressions if they are presentable, likable, and articulate. Overall, I’ve been burned by getting too close to management teams. Looking back on my investment history since inception (and even going back to 2008 as a private investor), the best investments I ever made were ones where I had limited contact with the board, management teams, and top shareholders.

It’s probably just the way I’m wired, but I just operate better when I can sit in a room and think for myself. I want to be able to debate the bull, base, and reasonable case on my own without any input from others. I trust myself to be right in my analysis and I don’t need others to validate my investment thesis. Management teams are savvy at pitching their companies and being extremely likable people in general. I just don’t want to be influenced by any of that. Furthermore, peer managers who take the opposite view are extremely smart. They are great at pitching and presenting their investments, so I can also be susceptible to being moved off of ideas. So I prefer to ignore management teams and fellow PM’s as a whole until I need some serious questions answered.

With that being said, I’ll still do calls with management teams and visit when needed, but I only do so to check a box. It feels almost obligatory because otherwise I feel like I’m skipping a step in the investment process. However, it’s not something that I absolutely need to do, and I don’t force myself to do it if I don’t have any pressing questions.

What I focus on instead is to figure out the key drivers of the business, analyze the historical numbers, make an attempt to project normalized earnings out 2 to 5 years, and purchase shares if the IRR is at least, say, 30% minimum. I just don’t want to see any red flags when it comes to the board/management team portion of the investment equation.  

Given that you focus on small companies, many of which have no analyst coverage, how do you generate your investment ideas? And has your process for finding ideas changed since your 2017 launch?

The process for idea generation has certainly changed since the 2017 launch. Back then, I used to read 13F’s and investor letters, look at idea sharing sites like VIC/Sum Zero/Seeking Alpha/Corner of Berkshire and Fairfax, and talk to fellow portfolio managers for ideas. And all of that worked. There’s nothing wrong with doing any of it. In fact, I achieved excellent returns going all the way back to 2008 as a private investor. Those methods of idea generation definitely work.

However, I just had an epiphany around late 2019 and early 2020 that I was a great investor with a solid track record. So why not generate ideas and write up companies on my own? I realized that I didn’t need to rely on others and their analysis to come up with great investment ideas. So I made the shift in my investment process and the fund’s performance improved significantly. 

Screens, newspapers, and targeted internet searches are the primary way that I generate investment ideas these days. I used to screen very rarely, but now I rely almost exclusively on screeners. However, I try to make the screens as broad as possible so that the list still has a few hundred companies on it. Then I’ll go through each company one by one and do a quick scan of the numbers and charts.

Newspapers are also useful. I’m sure most people don’t even read newspapers anymore, but I still find them helpful. They keep me engaged with what’s going on in the markets. Newspapers provide market sentiment, include what journalists and the general population feel are important, and occasionally have interesting articles about companies undergoing change or distress.

And of course, targeted internet searches can help you find exactly what you are looking for. It’s probably the best way to find special situations aside from newspapers. So whenever I’m not doing a deep dive on a company that fits our typical criteria, I’ll run searches to see if there are any interesting special situations where I can add a sub-5% position to the portfolio.  

How does your fund trade positions and manage risk? Specifically, can you please share a little about position sizing, turnover, concentration, and anything else relevant?

There are no hard and fast rules when it comes to position sizing. It depends on the type of investment, upside/downside profile, and conviction level. Generally, I like to slowly build the position because I can get more comfortable with a company as time goes on - especially if my expertise in the industry is limited. The typical sizing progression is 3%, 5%, 7%, 10%, 12%, 15%, etc. at cost. I don’t have a max position limit because you really have to bet big when you see a rare investment with huge multibagger potential and limited downside.

Others may disagree, but I don’t think it would be crazy to put 33% or even 50% of the fund’s capital in an amazing investment idea. With that being said, the largest position size we’ve ever had since inception was 25% at cost. Typically, investments are sized around 7% or 10% to start. It’s only the great ideas that exceed 10%. Conversely, it’s the special situations, companies with elevated downside risk, shorts, and tracking positions that are below 5%.

So there tends to be 5 to 10 core positions with smaller positions at any given time - which could bring the number of holdings to 15, 20, or more. I don’t really worry about how many companies there are in the portfolio. I’m primarily focused on the Top 5 positions because they are the key driver of returns. Additionally, the Top 5 positions will almost certainly be 50% or more of the portfolio, so I have to get those investments right. 

Turnover isn’t something I worry about. I don’t optimize the portfolio with taxes in mind. If I need to sell a company, I’ll sell. Whether it’s a short or long-term gain/loss, it doesn’t matter. Trading and managing risk is all about valuations, fundamentals, and the investment theses. Of course, I prefer to hold companies for the long term as long as everything is meeting expectations. For example, we’ve held Zengame (Hong Kong: 2660 — HKD$3.82 billion) since 2019 and Sprouts Farmers Market (NASDAQ: SFM — $7.89 billion) since 2020. On the other hand, I’ve cut my losses in companies or sold at a profit within a year of the initial buy. Like position sizing, every situation is different and it’s all valuation and thesis-driven. In short, I’m trying to get the highest net returns possible for my investors. Turnover is of minimal importance.

I would also add that I’ve added charts to my investment process in recent years. That may be sacrilege to the practice of value investing, but I want the odds stacked in my favor. I have respect for technical analysis, momentum, etc. and I’m not above using any of it to my advantage. If something works over the long term and it’s not detrimental overall to the practice of value investing, I’m willing to incorporate it into my investment process. The goal is to have a Hall of Fame track record, and you can’t do that without constantly evolving, improving, and learning as an investor.

Also, I’ve found that using technical analysis for entries and exits and trading around positions has added another dimension to the investment process. Subjectively, I think charts and technical analysis have enhanced returns, but we’ll have to see over the long term. So far, the net returns we’ve achieved since implementing technical analysis have been great.   

What are some of your favorite off-the-beaten-path ideas today?

Zengame Technology (Hong Kong: 2660 — HKD$3.82 billion) continues to be one of my favorite ideas. I’ve written about the company several times before, so investors who follow me may already be familiar with the name. However, the stock price is down ~35% YTD, which provides investors with an even better entry point at HK$3.71/share. It wasn’t too long ago in late December 2023/January 2024 that the price increased significantly and reached a 52-week high of HK$5.88/share. Despite the large decline, Zengame continues to be RF Capital’s top holding. We haven’t trimmed our position. In fact, we’ve been adding for investors that are underweight the company.

For those unfamiliar with Zengame, they are a developer and operator of casual mobile games in China. Zengame’s flagship game at the moment is Fingertip Sichuan Mahjong. (Mahjong is a popular board game in Asia.) Previously, Fight the Landlord, a card game, was the flagship. The company generates revenue through advertising and in-game virtual item purchases. Zengame employs the “freemium” business model, so the games are free to download and play.

One of the key drawing points of Zengame is that its flagship games are always ranked in the Top 5 of the iOS charts in its category. This continues to be the case with Fingertip Sichuan Mahjong - which still consistently ranks in the top 5 in the card and board games iOS bestseller list in China. To me, that indicates that Zengame is not only great at developing games that people want to play but also that they are on top of their marketing and tracking of current player trends. It’s difficult to be so consistent over multi-year periods with game development, especially with casual mobile games. Keep in mind that Zengame doesn’t develop complex games like RPGs, FPS games like Call of Duty, and other games that companies like Tencent are famous for.  Zengame focuses on casual games as well as card and board games that are quick and easy to play. Also, the marketing and advertising needs to be on point. It seems like the company is doing a great job through livestreaming as well as promoting its games through the usual channels like WeChat, ByteDance, and Kuaishou.

Additionally, Zengame’s numbers and valuation metrics have always been a “no-brainer” given its strong growth prospects. Although Zengame didn’t have the best half-year recently, the current multiples and valuation are still too cheap to ignore. First, the pre-tax ROIC is 47%, and that is before you take into account the large amount of cash on the balance sheet. Any time I see a high ROIC like Zengame’s, it indicates to me that the company has some sort of competitive advantage or edge whether that may or may not be visible at first glance. One would think there’s no moat to be had in the casual mobile games category, but clearly Zengame has made it work ever since the company IPO'd. The company consistently has high ROIC numbers. Second, the company trades at ~5x P/E and FCF.