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February 26, 2007

LAWBALL

I never saw an ugly thing in my life: for let the form of an object be what it may - light, shade, and perspective will always make it beautiful.

- John Constable (1776 - 1837)

Much in life is a matter of perspective, not just beauty.  Two people can look at the same set of facts and reach different conclusions simply because they have different perspectives.  Stephen Covey described this phenomenon as:

We see the world, not as it is, but as we are – or, as we are conditioned to see it. . . [C]learheaded people see things differently, each looking through the unique lens of experience.

Sometimes it helps to bring a different perspective to something in order to understand it better and to benefit from the mistakes of those who don’t.  In Moneyball, Michael Lewis wrote about a different perspective that has been brought to baseball.  Lewis said that he began his writing with a simple observation:  “Some baseball executives seemed to be much better than others at getting wins out of dollars.” When he finished the book (one about baseball and business that I highly recommend), he had captured how the Oakland A’s in a manner more akin to exploiting inefficiencies in financial markets had set about looking for inefficiencies in baseball and, by using a form of systematic scientific investigation to separate data from perception that was based on long-held individual images and beliefs, developed both a different way to value baseball talent and different metrics or key performance indicators for baseball.  These new metrics took advantage of what behavioral finance scholars have noted in the cognitive psychology part of their discipline – people make errors in the way they think and make decisions.  The A’s found that, just like financial investors, baseball talent investors generalized wildly from their own experience playing the game, were overly influenced by the most recent performance by a player, and were biased toward what they’d seen (or thought they’d seen) with their own eyes.

Recently (Metrics!  We Don’t Need No Stickin’ Metrics and Metrics! We Don’t Need No Stickin’ Metrics (Part II)) having bombarded the readers of this blog with a series of financial metrics for the business of practicing law, which I readily admit can be a powerful and sure-fire cure for insomnia, I thought it might be helpful to look at these legal industry metrics from a different perspective.  This different perspective is not one based on academic research or study – it’s just one based on an analogy that hopefully will make the metrics and their importance simpler to understand. 

Think of the business of practicing law as being the game of football – LawBall, if you will.  Like football, LawBall is competitive.  And, like football, there is a final result – in LawBall, it’s profit per partner (the functional equivalent to return on equity or ROE).  Just as a football team’s strategy must be in sync with its assets (its players) and what it does best in order to be successful – for example, be a running or a passing team on offense of play a 3-4 or a 4-3 on defense – LawBall requires that, in order for a “team” (or law firm) be able to achieve its best final result, its assets (lawyers) and what it knows and what it does must be configured in support of its strategy.   Finally, as football has 3 major team components that must be managed and executed well in order to win – offense, defense, and special teams – so does LawBall.  LawBall’s 3 major components are asset turnover (think offense), profit margin (think defense), and financial leverage (think special teams).

When one looks at what it expects from a football team’s offense, it expects it to score as many points as possible (think the 2006 San Diego Chargers or the Indianapolis Colts almost any year with Peyton Manning).  With a law firm, the expectations should be the same – the highest asset turnover (revenues per lawyer) possible.  When one looks at what it expects from a football team’s defense, it expects it to hold the opponent to a few points as possible, thus preserving as many of the points its offense scored and creating as big a margin of victory as possible.  Law firms should expect the same from its “defense” – profit margin – the firm should seek to keep its costs per lawyer as low as possible, thus creating the highest profit margin possible.  Most times in football, when your offense and defense combined are better than the competition, you should win; and, if the teams are relatively equal in those 2 areas, special teams can make the difference (think the New England Patriots when they had kicker Adam Vinatieri).  The same holds true with LawBall – remember, profit margin x asset turnover = return on assets (or ROA), and ROA is a good measure of the efficiency with which a business allocates its resources – but if the competition in LawBall as measured by ROA is tight, financial leverage can be the winning difference for ROE (ROE = profit margin x asset turnover x financial leverage).

Let’s take another look at what happened with Firm B by comparison to Firm A in the prior postings through the eyes of LawBall.  First, Firm A’s 2005 offense (asset turnover of $790,698) was much more explosive than Firm B’s ($518,116 asset turnover), despite the fact that the 9-year compounded annual growth rate (CAGR) of Firm B’s revenues was greater than Firm A’s (10.65% to 9.18%).  Over that same 9-year period, Firm B’s number of lawyers grew at nearly twice the rate of Firm A’s number of lawyers, resulting in Firm A’s asset turnover growing at a 9-year CAGR of 6.16% to Firm B’s 5.12%.  The effect of Firm B’s lawyer growth was like the effect of a high number of quarterback sacks or run attempts for losses on gross offensive yardage (revenues) – the negative plays result in a lower net offensive yardage output.  At the same time that Firm B’s offense was sputtering compared to Firm A’s, Firm B’s defense also was falling apart – it let much more of its net offensive output (asset turnover) be dissipated than that of Firm A’s:  Firm B’s 2005 profit margin had plunged to 34.84% from its 1996 level of 46.26%, while Firm A’s 47.84% profit margin for 2005 was slightly above its 47.10% level for 1996.   The combined effect of Firm A’s offensive and defensive dominance was a 2005 ROA (profit per lawyer) of $378,295 compared with Firm B’s 2005 ROA of $180,507.  Firm A’s 9-year ROA CAGR was 6.34%; Firm B’s was 1.86%.  Another way this offensive and defensive domination by Firm A is captured is to look at the asset turnover growth rate vs the growth rate of costs per lawyer (a major element of the “points given up” by the defense):  Firm A’s 9-year CAGR for its asset turnover was 6.16%, while its cost per lawyer CAGR was 5.99%; Firm B, on the other hand, had a 9-year asset turnover CAGR of 5.12%, while its costs per lawyer CAGR was 7.40%.  From 1996 to 2005, Firm B’s defense was giving up points at a faster rate than its offense was scoring.  A small bit of solace can be found for Firm B though – its special team play (financial leverage) improved from 1996 to 2005 to the point that the relative margin of its ROE defeat (Firm A’s ROE was 2.0192 times greater than Firm B’s) was slightly less than the relative margin of its ROA defeat (2.0957).

In LawBall, Firm A clearly outplayed Firm B.  Why?  Firm B’s performance probably was the result of a combination of actions and non-actions by it.  First, regardless of the type of “defense” Firm B played – the 3-4 or the 4-3 – it did a poor job of tackling its costs per lawyer.  Second, despite the rate at which it gained gross yardage (its 10.65% CAGR for gross revenues) on offense, it had too many “bad plays,” including growing the number of its lawyers too fast, resulting in a net yardage (asset turnover) growth rate below that of Firm A.  Firm B’s game plan – its strategy – likely wasn’t in sync with its assets (players/lawyers) and didn’t mesh with what those players did best.  Best guess:  the field of play for Firm B changed over the years, as the rate of specialization accelerated causing Firm B’s business to move from one that required a lot of complex problem solving to one that was more standardized or more “fungible.”  Instead of changing its pricing strategy to one that was more appropriate for its new fungible business base, it likely tried to move its rates up to the highest level it could, as if it still were doing complex problem solving, costing it business.  And, It probably kept the same mix of assets (type of players) that it had when it was doing a greater volume of complex problem solving.  Just like in football – in LawBall, a bad strategy and poor execution leads to poor performance relative to the competition.

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