Brandon Schauer: For those who aren't familiar, can you tell us about Kairos?
Russell Redenbaugh: Kairos, our company, has an unusual name. It comes from Greek and translates roughly to "the moment when opportunity and action meet." At Kairos, we do investing and advising. On the investing side, we seek value in public companies before it is recognized in their stock prices. This is what all investors do. On the advising side, we consult with companies on business problems affecting their market share, profitability and therefore their valuation.
Natalia Davis: What makes our approach unusual is that we see businesses and financial markets as networks of people. We study the interactions of human beings. We see each company as a network of people working together toward a common purpose. This sounds simple, but people can be complex and for them to change can be difficult. As investors we see the marketplace as a network of people interacting through story and behaviors. We look for changes in the way people are interpreting things, and for changes in their behaviors. We don't study financial statements. We study people and we look for the footprints of change.
Russell Redenbaugh: In fact it was our study of people that lead us to the ID Strategy Conference last year. It had been clear to us as investors that design was becoming increasingly important. We wanted to learn more about design and designers so we could make better interpretations about where value would show up.
Natalia Davis: What we saw at the conference was that designers understand that design is valuable, and that their clients are people in organizations who see that value. We found that many designers think design is "intrinsically" valuable and therefore demonstrating its value is unnecessary. By not measuring value, a designer limits his opportunities. Not everyone sees the value of design. That's good because it allows design to be a differentiator.
Russell Redenbaugh: We are not designers. I am an investor. Natalia is a business anthropologist. We watch people. In doing so we came to see the value of design. We are early in this view. The whole world hasn't yet caught on; it will. Designers may think we are late to this realization but we know we are ahead of the investment curve. That is where investors like to be.
BS: I can see measuring the value of a design after the fact, but how could you ever show the value beforehand?
Natalia Davis: If it can't be measured, it doesn't matter. Designers need to find metrics, pre-metrics or pseudo-metrics that are footprints for increasing value. Sometimes this is not easy.
Russell Redenbaugh: Peter Keen, with whom I've worked in the past, gives an apt example in his book titled "Competing in Time." He writes about the ATM, which beforehand couldn't demonstrate a positive return on investment. In fact the puny service charges didn't even cover the costs of the machines. But the entire point of contact with the customer changed from the bank teller to the ATM. Almost overnight the ATM went from being a "bad" investment to essential. Every bank needed ATMs to do business. It dramatically reduced the demand for tellers, pricey lobby real estate and Italian marble.
Natalia Davis: Although the monumental impact the ATM would have on the banking industry could not be foreseen or measured accurately, there were metrics hinting at a positive return. One could measure the reduction in teller costs per transaction. How many tellers would an ATM machine need to replace in order to recover its cost? When you consider all the annual costs of salary and benefits for a teller, you don't need to replace very many of them to more than pay for the ATM.
This doesn't even account for the time saved by customers not waiting in line, not rushing to get to the bank before it closes and not searching for a parking space. Time is a powerful metric that often is overlooked. As our friend George Gilder often reminds us: "Time is the scarcest of resources because time is the only nonrenewable resource." It is for this reason time is the most valuable resource.
BS: I notice you report on the larger social trends. How did you see that design was becoming more important?
Natalia Davis: We've been following IDEO for half a decade. What is interesting about IDEO is that they started as award-winning product designers. They then applied these design principles to business services, not just products. This may not sound unusual, but at the time it was. We also saw companies, such as Procter and Gamble, who employed design teams focused on business, not just products. These are the kind of footprints we mentioned earlier that showed us that the influence of design was spreading. At last years IDSC, we realized that design's influence was spreading more than we had previously recognized.
BS: Now that you see design's influence spreading, how does this affect Kairos' investing and advising?
Russell Redenbaugh: We see growth in the market segment that will pay for good product design. Given this, we would invest in Target over Sears. We would invest in Victoria's Secret over Warnaco. We have invested heavily in Apple over Microsoft. Steve Jobs after all is the quintessential designer. It is his time. In the last two years, Apple [share price] has gone from $13 to $70 while Microsoft has gone from $25 to $26.
Natalia Davis: Our clients often ask us "What is the next Apple?" The better question is "Who is the next Steve Jobs?"
BS: When you use the term "design," what do you mean by it? As investors, what makes a good designer?
Russell Redenbaugh: Very interesting and tough questions. Most good designers are given a problem to work on by their clients. They design a solution in the form of a product or service. This results in an improvement that is valued by the client and its customers. Incremental product improvements are common examples of this. Think Gillete's Fusion razor.
Great designers see opportunities and move swiftly to act on them. Steve Jobs is the archetypal great designer. As investors we love him. He designs not only things but also the experience surrounding those things such as customer support and service. Most unusual is that he also designs business models. His success is well known. There's the iPod and iTunes, Pixar, and the new Intel-powered Macintosh.
Natalia Davis: Following on Russell's example of entrepreneur as designer, let me elaborate on how we look at the design of companies. In the beginning an entrepreneur may start out designing a product or service in his spare bedroom with no one to satisfy but himself, his own high standards. If, however, he wants to end up with a business that matters, he is going to have employees, customers and shareholders who will have to be satisfied. We call these three constituents "The Holy Trinity."
Let me just describe the generic scenario. An entrepreneur designs a product or service. He hires employees to help him build the business. Now he has employees who need to be satisfied through more than just compensation. Incentives have to be designed to produce the behaviors necessary for the business' success. Soon the business has customers, another group to satisfy. Metrics need to be in place to measure customers' satisfaction. Surveys are useless. Revenue may not be a measure of customer satisfaction. If the business continues to prosper, it will have shareholders and possibly public shareholders. This group needs to be satisfied by a growing valuation. If it's a public company, this may not be easy because many shareholders think in terms of calendar quarters. This is a simplistic view of a company and the roles of the "Holy Trinity."
Russell Redenbaugh: This perspective is useful for seeing where the problems and opportunities lie within a business.
BS: So you approach investing and advising using the framework of the "The Holy Trinity"? Are you always looking at employees, customers and shareholders?
Natalia Davis: That's right. Let us give another example of this. Every business wants to be a monopolist. They want to build a barrier that keeps competitors out and customers in. They don't want customers to have choices. Think Microsoft! They do whatever necessary to keep their customers from bolting. Incremental improvement is one example. Government regulation is another. The bundled versus a la carte pricing used by the cable industry is an example of companies using government regulations to lock in customers.
Russell Redenbaugh: Monopolies often produce a situation investors love: a return on capital much higher than the company's cost of capital. Companies in this situation are often celebrated by Wall Street - but only temporarily, as they are often in grave danger.
Natalia Davis: This condition we call "Resentful Bondage." When customers are held hostage by barriers to exit that are too high, deep resentment and anger sets in. This can lead to a revolt! As you know, we've written about this in our newsletter titled "Beware the Resentful Customer." [pdf] Let me briefly explain for those who don't have the time or interest in visiting our blog, readingtheworld.com.
We'll use the well-worn story of the record industry. For decades, the record industry grew through a series of innovations. Remember the 33 rpm record, the 45, the cassette tape and then the CD? Along with these products also came a growing selection of artists and music. By giving its customers better products and greater music variety, the record industry prospered. At some point, however, the record companies began to take more than they gave. Their insistence that customers pay for 12 songs when only 3 were desired produced widespread resentment. Unfortunately for the customers, they were unable to buy their music elsewhere. They were held hostage paying increasing CD prices. Caught in resentful bondage, they got angrier and angrier.
Soon Napster, followed by Kazaa, offered music customers a choice. Seventy million users flocked to Napster in just two years. Many think this is because Napster was free, but Steve Jobs knew better. It was because those customers were mad! iTunes proved that these users were willing to pay for music but that they were no longer willing to be held hostage paying for entire CDs rather than individual songs. The move to digital downloads happened quickly because it was fueled by customers' powerful emotions.
Russell Redenbaugh: When a company takes more than it gives, it puts its financial future in jeopardy. Perhaps the new products and services are more than the customer can use and therefore a price increase isn't warranted. Clayton Christenson calls this condition an "overshoot." When customers are forced to pay for products they don't value, resentment grows. Desiring freedom, they will rush to the first available choice. It doesn't have to be the best choice, just an alternative.
Natalia Davis: This leaves companies vulnerable to what Christenson calls "disruptive technologies." These are competitors who offer customers choices, nearly always at the bottom of the market, but choices nonetheless. The point is that they don't have to be good, just good enough. Think of the digital camera, low cost imported cars in the 1960s, and the PC.
BS: If there is a large pool of customers living in "Resentful Bondage," does this produce an undiscovered market? Where else do you see undiscovered markets?
Natalia Davis: The poor.
Russell Redenbaugh: Every month there are tens of millions of people moving from subsistence farming to a market economy. In China and India, the agricultural, industrial and information revolutions are all happening simultaneously. What Western civilization took 150 years to do, China, India and others are doing in one generation. This represents an enormous increase in the supply of labor and the demand for products.
Natalia Davis: C.K. Prahalad writes and speaks on this subject brilliantly. He refers to this market segment as the "Bottom of the Pyramid" or the "Business of the Poor." It is an unfathomably large market segment. In China alone there are more cell phones than there are people in Canada, the U.S., and Mexico combined.
BS: Russell, as an economist, aren't you concerned that outsourcing to all these new workers in China and India is a threat to the U.S. economy?
Russell Redenbaugh: No, not at all, but it does pose an important design problem.
BS: What do you mean?
Russell Redenbaugh: The entire history of the Industrial Revolution is based on giving up or "outsourcing" low-value-added activities. The notion of comparative advantage developed by David Ricardo, the famous British economist born in 1772, is that countries should concentrate on those activities they do best. American companies are designing with this principle in mind, as they should. Products intensive in unskilled labor should not be made in the U.S. The U.S. advantage is in products that are design intensive. Our comparative advantage is in intellectual property, product design and business model design. It is not in embroidery.
The U.S. is experiencing a cash storm. Our capital markets give us a huge advantage. Global investors are buying our stocks, bonds and buildings. This is evidence that Americans are doing it right.
Natalia Davis: The "outsourcing" problem is exactly the opposite of what politicians say. We are heading towards a labor shortage, not a job shortage. Unemployment in the U.S. is less than 5 percent while in other countries like Germany it is 12 percent. We need to focus on the coming labor shortage. By 2010 the U.S. professional labor markets may lose as many as 10 million workers. These workers will leave behind jobs requiring skills that cannot easily or quickly be learned or outsourced. How can you outsource a dentist or nurse?
BS: Are you referring to your newsletter titled "The Perfect Storm," [pdf] where you write about different generational forces at work?
Natalia Davis: Yes. This shortage of professionals is happening because three generational forces are at work. First, the Baby Boomers are retiring at an earlier age. The average retirement age has dropped from 67 to 61. Rising insurance costs for malpractice are driving some seasoned healthcare professionals out earlier than planned. Secondly, Generation X women are leaving the workforce to be mothers. Many of these professional women have realized they can't do it all at once. They are opting to care for their family over work. Many have seen the cost of absentee parenting and are not willing to have daycare or nannies raise their children. Last, Generation Y's young people are delaying their entry into the workforce by opting for higher education. Record numbers are competing for placement in law schools and MBA programs. Having lived comfortably with their parents, they want the same for themselves.
BS: How can we address this coming shortage of professional labor?
Russell Redenbaugh: I'm not sure, but again, it is a design issue. Fortunately businesses respond more quickly and more accurately than politicians to economic forces. We are already seeing private, for-profit universities vocationalizing professions. For example, the University of Phoenix online offers courses which allow graduates to enter the accounting field without becoming full CPAs. Segmenting the profession allows people to do a portion of the job under the supervision of a fully credentialed experienced professional.
Vocationalization is an example of, one, redesigning education using the criterion "how much is enough?"; two, redesigning work using the criterion "What skills or competences are needed for each part of the work?"; and three, redesigning management from the perspective of the question "How do you use your professionals to manage others rather than do all the work themselves?" Not everyone in the finance department needs to be a CPA and MBA. This vocationalization is the modern-day Taylorism of professions. As the father of Industrial Engineering, Frederick Taylor re-engineered factory work using segmentation.
Lawyers have already been doing this somewhat. They often have senior partners, partners and junior associates who are supported by paralegals, specialists and secretaries.
BS: You've written a lot about demographics and generational change. Will you give us an example?
Russell Redenbaugh: Let me give an example that might not be very exciting, but that is clear: Europe is going to stop being Europe. Their birthrate has fallen so low that they're running out of Europeans.
The problem with this is that their social welfare systems, retirement systems, and pension systems are all predicated on having a large and growing workforce, which they don't have. The birthrate in Western Europe would need to increase about 50 percent to achieve a zero population growth rate.
Natalia Davis: In Japan, it's even worse than Europe. The birthrate in Japan would have to double. It has been below the replacement rate for nearly 30 years. Given that Japan has a no-immigration policy, and only 250,000 immigrate there per year, they truly are running out of workers. And given that it takes 18-20 years from conception to get a worker, it's a problem that can't be solved anytime soon. This has enormous consequences for the Japanese economy and the Japanese investment markets.
We wrote about this as far back as 2002 in our article "Japan's Death of Birth" [pdf]. Recently, it's been getting more attention. People are beginning to grasp the gravity of the problem. These are issues that can't be solved in less than two decades. The math is just against the solution.
BS: So how do you act on these changes in demographics to find value for your investors or clients?
Natalia Davis: In Japan, you see that they're trying to change policies, but you can see these policies won't affect the fundamental problem of the low fertility rate. Accordingly you would not invest there.
In Europe, they're going to have to deal with the very heavy burdens of their social programs, yet they don't have any solutions prepared. You see that affecting their economies. In many of the Western European countries public employees can retire with full pension at the age of fifty.
In China, the situation is more complex. China's successful one child policy produced three dire consequences: one, they have a shortage of women to marry. Two, they are not replacing themselves. And three, their population is aging rapidly without a retirement system in place.
BS: You've pointed out the problems Japan and China are encountering due to fertility rates below replacement level, but what about the U.S., whose fertility rate is about 2.0, meaning just at the level of replacement?
Russell Redenbaugh: Before I answer your question, I just want to point out that all retirement systems are legalized inter-generational chain letters. To succeed, these social programs can't be supported by a workforce that is small when compared to the size of the retiring population. There must be a pool of workers that is larger than the pool of retirees.
Now let me answer your question about the U.S. Here, everyone is familiar with the problems associated with Social Security. We see that the next generation of workers is too small to support the retiring Baby Boomers. Fertility rates are not the problem in the U.S. The problem is a generation gap between the Boomers and the generation that follows them, Generation X. This generational gap is the subject of a book Natalia is writing.
Natalia Davis: Well, the topic of my book is really change. We see this next generation, Generation X, as the carriers of change. These changes are happening in business, politics, family and education. With its members now entering their forties, Generation X is clearly gaining power. As the aging Boomers retire, Generation X will gain even more power. We study generational changes because it allows us to see the future. As investors this is how we make money for our clients.
Russell Redenbaugh: I am a Boomer. My generation is idealistic. We are good at stamping our feet, as evidenced by our widespread protests. We are committed to our own comfort and we expect others to pay for it. Just this week CNN dedicated a series to the topic: "Boomers disappointed that their parents won't leave them enough money." Boomers don't want to reform Social Security. Boomers want to and have expanded Medicare. Boomers expect the government, which really means the next generation, to pay for their retirement. Boomers have undersaved and overspent, yet they expect to live well forever.
Natalia Davis: In contrast, Generation X has been saving earlier and more than their parents. More than half of them have financial advisors. As an X-er, I am worried about my financial security and retirement. We believe that we're much more likely to be abducted by an alien than to receive one dollar from Social Security. The difference is, as realists, we are saving for our future.
Generation X is very different from the Baby Boomers in their attitudes, values and behaviors. As the first generation after WWII, the Boomers grew up in a time of unremitting prosperity.
Generation X, however, born between 1961 and 1981, grew up in economic scarcity with double-digit inflation, gas lines, high taxes and high unemployment. One third of Generation X children slipped below the poverty line before the age of six. As an X-er, I've experienced poverty and I don't want to go back. This is why we save.
Boomers typically grew up in a traditional home with neighborhood schools, Mom as the homemaker and Dad home by 6:00. This was a safe, even if perhaps restrictive, upbringing.
Generation X grew up in a very different way. Both parents generally worked. Half the parents got divorced. School often involved bussing to a strange neighborhood. Latchkey kids were common, self-taught and self-parented. This is in stark contrast with the Boomer's upbringing.
Having experienced the hardship of their parent's divorce, many Gen-X women are leaving their jobs and choosing to be stay-at-home moms. As I did with my nephew, many are choosing to homeschool their children. There is a widespread return to "family first."
BS: What are the implications for design of these changes in values?
Russell Redenbaugh: Designing products for Generation X is different than for Boomers. Generation X is interested in design. Unlike the Boomers, they appreciate form and function over luxury. Even if they have money, Gen-Xers are much more likely to shop at Target than Neiman Marcus. As we said earlier, it is Target's attention to design and value that had us invest.
Natalia Davis: Target has Michael Kors, Isaac Mizrahi and Cynthia Rowley designing clothing and home décor with affordability in mind. Target's products are sold at price points not normally associated with these designers.
Russell Redenbaugh: There are also many X-ers designing different kinds of businesses. Think Amazon, eBay, Yahoo and Google. These are just a few, but think how rapidly they affected our lives and the profit margins of well established businesses. Barnes and Noble is suffering. The newspaper industry is dying away. Retailers are being replaced by e-tailers. Broadcast and advertising agencies keep losing share.
Natalia Davis: Fertility clinics are on the rise catering to Gen-X women. Homeownership and stock ownership have never been higher. All these are some of the trends we are seeing as we study this group.
Natalia Davis is the managing director of Kairos, Inc. Natalia advises companies in strategy development and implementation. Some of her clients include Applied Materials, AT&T, ABB and KLA. She is currently writing a book on change. Natalia is considered by her colleagues to be a business anthropologist. Her study of people, in particular in networks, is both the basis of her consulting and her book. Her insights directly affect the investment process at Kairos.
Russell Redenbaugh is the founder of Kairos, Inc. Although an economist by training, Russell has served as a security analyst, portfolio manager, Chief Investment Officer and CEO. He holds two software patents. Russell was a founding partner of Cooke & Bieler, a Philadelphia based investment management firm which managed over $6 billion in stock and bond assets. Natalia and Russell have written a number of articles. These have appeared in Shareholder Value magazine, The American Spectator magazine, and under the auspices of the Lexington Institute. Both have lectured at the Wharton School of the University of Pennsylvania and at the New York Society of Security Analysts. You can find Natalia and Russell on the web at www.kairos-inc.com and their insights on readingtheworld.com.
Brandon Schauer is a senior practitioner for Adaptive Path, a leading user experience company. He has nearly a decade of experience developing new products, services, and user experiences for the Web, handhelds, and more. Brandon received a Master of Design from the IIT Institute of Design in Chicago, where he studied the planning, development, and management of innovation. Concurrently, he graduated with an MBA from the IIT Stuart School of Business.
