How to avoid being ruined by a Patisserie Valerie-style disaster

This is a guest post from Tim Price, acclaimed value fund manager and regular MoneyWeek contributor. Come and see Tim talking to MoneyWeek executive editor John Stepek and Iain Barnes of Netwealth on 12 February get your tickets here now.

"We're not looking for fraud or the future or giving a statement that the accounts are correct We are saying they're reasonable, we are looking in the past and we are not set up to look for fraud." - David Dunckley, chief executive of Grant Thornton, giving evidence to the Business, Energy and Industrial Strategy Committee after the failure of its audit client, Patisserie Valerie.

If you want to be soundly depressed about human nature, read No One Would Listen by Harry Markopolos. Remember Bernie Madoff's $64bn Ponzi scheme? Grupo Santander probably does. As, presumably, do Fortis Bank, HSBC, UBP, Natixis, RBS, BNP Paribas, BBVA, Nomura, Tremont Capital, Axa, Dexia and Unicredit just some of the entities who ended up with over $100m exposure to Madoff's, erm, creative accountancy.

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On five separate occasions, beginning in 2000, Harry Markopolos warned North America's Securities and Exchange Commission, the SEC, about the Madoff fraud. In his 2005 submission alone, Markopolos highlighted 30 reasons to suspect Madoff of fraud. Reviewing the book, market commentator and author James Grant offered the following: "How to improve financial regulation and reduce the federal budget deficit, all in one fell swoop ? Fire the SEC. Hire Harry Markopolos."

The spirit of Bernie Madoff is alive and well and now manifest somewhere in the wreckage of Patisserie Valerie, the coffee and cake chain that has just collapsed with a mysterious £40 million black hole at the centre of its accounts. Investors should feel rightly indebted to JK Galbraith for coining the term "the bezzle" in his fabulous account of the 1929 US stockmarket collapse, The Great Crash:

"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist, embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.)

"At any given time there exists an inventory of undiscovered embezzlement in or more precisely not in the country's business and banks. This inventory it should perhaps be called the bezzle amounts at any moment to many millions of dollars. It also varies in size with the business cycle.

"In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly.

"In a depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks."

Grant Thornton CEO David Dunckley may have been technically accurate when he told a parliamentary committee this week that the auditors are not stating that the accounts are correct, or that they are looking at the past, or that they are not set up to look for fraud, but his statement does rather raise the question of what the hell an auditor is being paid for.

Perhaps RMS Titanic never promised safe passage to its customers. And, yes, Emperor Hirohito of Japan was linguistically veracious when he told his fellow citizens after the atomic bombing of Hiroshima and Nagasaki that "the war situation has developed not necessarily to Japan's advantage".

If you require an education in economics, don't reach for your wallet and look to the LSE. Just bear in mind the following observation from Steven E Landsburg: "Most of economics can be summarised in four words: People respond to incentives.' The rest is commentary." And as ever, Berkshire Hathaway's Charlie Munger deserves the last word on the topic: "Show me the incentive and I'll show you the outcome".

If people are determined to commit fraud, there is probably not much any of us can realistically do to stop them.

We do recall what won us over to investing in Vietnam, however, roughly three years ago apart from the extraordinarily attractive valuations and growth prospects of this admittedly frontier market. We met with the chairman and chief executive officer of the country's largest securities broker. We confessed that we had some questions about the standards of corporate governance in the country. She responded that they had indeed experienced a fraud perpetrated by the bank manager of a local bank. As a result he had been executed.

There are, however, certain steps one can take at least to minimise the risk of fraud and the related risk of catastrophic capital loss. One is obviously to develop an acute judgment of other people's character. One is not to invest in banks. One is to allow oneself to be naturally drawn to superior allocators of capital, running shareholder-friendly businesses in which they already have a meaningful equity stake. And one is to diversify anyway, because you simply never know.

Tim Price is co-manager of the VT Price Value Portfolio and author of Investing through the Looking Glass: a rational guide to irrational financial markets'. John Stepek will be discussing the current state of markets with Tim and Netwealth's Iain Barnes on the evening of 12 February book your tickets now!