WHAT’S GOOD FOR THE GOOSE IS GOOD FOR THE GANDER . . . AND MAYBE EVEN BETTER

Warren Buffett, Chairman of the Board of Berkshire Hathaway Inc. and perhaps the pre-imminent investor of our time, says he “buys businesses, not stocks.”  He also believes a stockholder and a business owner should look at ownership of the business in the same way and says, “I am a better investor because I am a businessman and a better businessman because I am an investor.”  Interesting comments – but what do they have to do with the business of practicing law?  And why should lawyers care?  The answers can be found in Buffett’s approach to buying and owning businesses.

In The Warren Buffett Way, Robert Hagstrom outlines a set of basic principles, or what he calls “tenets,” that have guided Buffett’s decisions.  According to Hagstrom, Buffett makes investment decisions based only on how a business operates; and, as a result, Buffett concentrates on learning all he can about the business under consideration.  In what Hagstrom calls “Business Tenets” (the others are “Management Tenets,” “Financial Tenets,” and “Value Tenets”), Buffett focuses on whether the business (1) is simple and understandable, (2) has a consistent operating history, and (3) has favorable long-term prospects.  Hagstrom notes that Buffett understands the revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs of every one of Berkshire Hathaway’s holdings.  With respect to the Financial Tenets, Hagstrom says among other things Buffett also looks at return on equity, as he believes the test of economic performance is whether a company achieves a high earnings rate on equity capital (“without undue leverage, accounting gimmickry, etc.”), and looks for companies with high profit margins.  Buffett, in effect, learns the “story” of the businesses.

Peter Lynch, vice chairman of Fidelity Management & Research Company and another premier investor and money manager of our time, expresses similar sentiments.   Lynch also believes that before investing one should develop the story.  In his best selling book One Up on Wall Street, he says, “Investing without research is like playing stud poker and never looking at the cards.”  To make his point further, Lynch admonishes investors among other things to:

• Understand the nature of the companies you own and the specific reasons for holding the stock.

• Devote at least an hour a week to investment research.

• Invest at least as much time and effort in choosing a new stock as you would in choosing  a new refrigerator.

Most business lawyers probably recognize that their clients do the same thing in conjunction with buying a company, business, or asset – except they often call it “due diligence.”  Every acquisition or investment has a story; and that’s what due diligence is about – it’s a method and/or process for getting the story.

I believe the single biggest investment lawyers make is the investment they make in their law firm.  This especially holds true for the partners (or whatever the nom du jour for “equity stakeholders” in a firm may be).  The investment isn’t necessarily cash; in fact for most lawyers significantly all of the “investment” is the blood, sweat, and tears they “spend” that is converted to intellectual capital in the business.  But the form of the investment doesn’t diminish the nature of its impact or significance to the “investor.”  For that reason, I simply don’t understand why most lawyers, particularly the partners who both are managers and owners of the business, “play stud poker and never look at the cards.”  One would think that what’s good for Buffett and Lynch would be good for lawyers – and maybe even better.  But lawyers apparently don’t seem to think so; maybe it’s because enough firms are playing without looking at the cards that the others can’t resist what Buffett calls the “institutional imperative” - the lemming-like tendency of corporate management to imitate the behavior of other managers, no matter how silly or irrational that behavior might be.  Or, as Buffett said in his 1989 Chairman’s Letter to Berkshire Hathaway’s stockholders, “[R]ationality frequently wilts when the institutional imperative comes into play.”  But whatever the reason, when it comes to their own firm’s business of practicing law most lawyers don’t do what Buffett, Lynch, and clients do when they make investments – that is, learn the “story” and then keep current on the story.  That means understanding the firm’s business model, operating history, and long-term prospects.  It means understanding the competition.  It means playing “LawBall.”  That’s the real benefit and value of “playing LawBall” – it’s about learning, and staying current with, the story of the firm’s business of practicing law.  It’s about looking at the business with a panoramic view that spans multiple years, not just an annual snapshot.  It’s about actively managing the business to improve financial operating performance.

As I’ve said in prior posts, using LawBall and looking at the return on equity (ROE) components it encompasses simply at a given point in time is interesting but not very helpful alone. One can see what happened at that point in time, but not why things happened.  Its greatest value is looking at the information over a period of years.  How and why did ROE change over time?  What happened in the 3 ROE components (margin, asset turnover, and leverage) that contributed to the change?  What happened to your competition over that same period of time?  At the same time, you also can drill down into each of the components to find what led to their changes; e.g., was a revenue increase the result of increased volume, increased pricing, or both? 

I’m going to leave you with some interesting information from the 2005 operating year to contemplate.  Set forth below is a LawBall-type look at 5 firms from The American Lawyer’s 2006 AmLaw 200 survey.  Each firm was chosen because it ranked number 1 in at least 1 of the LawBall operating measurements.  Some firms, e.g., Wachtell Lipton, ranked 1st in several categories.  For each firm, all of the LawBall financial operating measurements are included in the top portion of the chart.  The firm’s ranking in each category is included in the bottom portion of the chart.  As a result, for a firm that finished 1st in one category you can compare it’s overall performance with that of another firm that finished 1st in a different category.  For example, Skadden Arps had gross revenue of $1,610,000 and ranked 1st in that category, while Gordon & Rees is included because it ranked 1st in leverage (at 11.0455!).  In addition, in the middle of the chart are the financial operating performance numbers for the aggregate top 200 so that you can compare the firms in the select group below to the performance of the entire 200 as a whole.  Since the chart likely is difficult to read within the blog, click on it, and a larger version should open in another window.  I’ve also attached it as a *.pdf document in the right-hand margin under the category “Posting Attachments” as “Top 200 Operating Lever Leaders.”  Take some time to think about the data – and particularly what it could show you if you had 5 years of data to compare for each of the firms.  What would it tell you about the firms’ business models?  What would it tell you about their trends?  How would your firm compare?  Which firm’s performance more closely mirrors that of your firm?  What changes to your business model would you make based on seeing what the competition is doing?  How surprised are you that Wachtell Lipton was 49th in gross revenue, 18th in profit, 170th in leverage, and 199th in costs per lawyer – and still finished 1st in ROE on the strength of its margin (2nd) and asset turnover (1st), which gave it 1st in return on assets (ROA)?  What do you take away from Wachtell Lipton’s performance or, say, from Gordon & Rees’ performance - 9.87% margin (200th), profit (200th), ROA (200th), leverage (1st), and ROE (151st)?