On July 15, 2005, CNN aired a piece about Lance Armstrong titled "Superman on Wheels." They explained Lance gets twice as much oxygen for every breath as a healthy 20 year old.
This should have been a red flag for skeptics, but for most of us, we used it as the rationale for his success. We didn't stop to think how unnatural it is for a 35 year old who had been through chemotherapy to be twice as physiologically superior as a 20 year old. If we would have, we wouldn't have been so shocked when a mountain of drug abuse allegations came out.
For companies operating in the same industry with no durable competitive advantages, the laws that apply to Lance Armstrong also apply to them. When certain ratios, like profit margins, get out of line with competitors, it's psychologically easy to attribute this to an overly competent management.
WorldCom was like Lance Armstrong.
In Dan Reingold's Confessions of a Wall Street Analyst, he mentions, "by 1993 it [WorldCom] had become the fourth-largest provider of international long distance services behind AT&T, MCI, and Sprint, with the fastest growth rates and highest profit margins in the industry." Yet, why exactly did WorldCom have such superior results?
Just like Lance's competitors, WorldCom's competitors were baffled.
"WorldCom’s efficiencies and synergies had been, up until now, the envy of executives at Sprint and AT&T. Even as WorldCom faltered, executives at AT&T and Sprint remained completely obsessed with understanding how WorldCom managed to get its costs so much lower than their own," Reingold wrote.
In the end, Reingold explains how the fraud got perpetuated:
"The fraud, it turned out, had occurred mostly in the way line costs were accounted for. Line costs were those costs WorldCom paid to local phone carriers for originating and completing phone calls (the so-called last mile) and were WorldCom’s single largest expense. Apparently, Scott Sullivan and whoever else knew about it had decided to capitalize line costs, which meant spreading the costs over ten or more years instead of over one year, which juiced earnings and just so happened to be totally inconsistent with accounting rules. The idea of messing with such a large and important part of a company’s business was so audacious that it never occurred to most people that someone would try to do such a thing. It was the elephant in the room, the fraud too huge to fathom."
For WorldCom its line costs were significantly lower than competitors. For Autonomy, it was a receivables to revenue ratio unreasonable for a software company. For Lance, it was an oxygen absorption that was inhuman.
When things are too good to be true, it's important for an analyst to be guarded. Financial ratios might be a boring part of analysis, but it's an important one that must be based on reality.