The list of high-flying world-beaters exposed as nothing more than frauds has a new member: blood-analysis company Theranos. At one point valued at $10 billion, this private company for years was hoodwinking investors and -- more alarmingly -- patients, with machines that didn't work and results that were highly suspect.

While the company began to unravel back in 2016, last month's release of Bad Blood -- written by Wall Street Journal reporter John Carreyrou, who was largely responsible for exposing the fraud -- put a spotlight on how such a huge fraud could happen.

Woman working in a laboratory, writing with a felt pen

Image source: Getty Images

While no public investors like you and I directly lost money on Theranos -- the company never went public -- there are still lessons we can learn from the company's implosion and apply when selecting stocks for our own portfolios.

The power, and peril, of an enticing narrative

As human beings, we've created some amazing tools: We've landed on the moon and mapped the human genome. But in terms of manipulating behavior, actions, and beliefs, the most powerful tool at our disposal is also the oldest: a really good story.

That power doesn't have a moral compass: It can be used for both good and evil. Just think of how made-for-Hollywood the story of Elizabeth Holmes, the founder of Theranos, was:

A girl with fear of needles and deep desire to help the world drops out of Stanford. She starts a company that can analyze blood, predict future health maladies, and save untold lives at a fraction of conventional costs...and all that's needed is a small finger-prick of blood. She becomes a sign that women can succeed both in Silicon Valley and in the sciences -- inspiring scores of young girls to follow in her footsteps.

Time and again, as Holmes tries to convince investors and medical professionals her technology works, their misgivings fade away as they fall under the spell of a really good story.

Nowhere was this more apparent than in a fascinating sequence of events in 2008. Alarmed by the machine's inability to do what Holmes said it could, Theranos' board of directors decided to remove Holmes as CEO.

"Then something extraordinary happened," Carreyrou writes. "Over the course of the next two hours, Elizabeth convinced them to change their minds." Her story -- and the charm she used in relaying it -- was intoxicating.

If a CEO can do this to her own board -- just after they have decided to axe her -- we should never underestimate the power that a good story can have over our own investments. To that end, there are three approaches that can help us filter out the power of a good story from our investment decisions.

1. Culture matters

When a company is perpetrating a fraud, there are bound to be employees with misgivings.

That's why I frequently use Glassdoor.com as a data point in my own stock-picking process. The site allows anyone to submit an anonymous review about a company they work for. It then tabulates all of the reviews and offers up an overall score (from one to five stars).

As you might expect, the tool isn't perfect. Human resources departments can get employees to submit doctored reviews, and short-sellers can contribute nefarious reports without a shred of evidence. That's why it's important to go beyond the numbers and actually read the reviews. Over time, you can get a feel for what's a genuine review, and what is meaningless spam. And in the end, this is a data point, not the data point.

My own investment decisions have been informed greatly by some of what I found on the site. For example, I once backed away from an investment in a bank based, in part, on what I read on Glassdoor. A few months later, a suit was brought by a former employee against the company and the stock cratered.

Anyone who checked out Theranos' Glassdoor ratings before the first Wall Street Journal report would have found several red flags. Carreyrou even highlights one in the book that sent Theranos's COO at the time into a tirade:

How to make money at Theranos:

  1. Lie to venture capitalists
  2. Lie to doctors, patients, FDA [Food and Drug Administration], CDC [Centers for Disease Control], government. While also committing highly unethical and immoral (and possibly illegal) acts.

2. A circle of competence is paramount

One of Warren Buffett's golden investing rules is to stay within one's own circle of competence. It's a simple way of saying that you should only invest in things that you truly understand. Peter Lynch -- another world-beating investor -- believed that if you couldn't explain how a company works to a child, with just a crayon and a piece of paper, you probably shouldn't be investing in it.

That advice would have gone a long way in helping those duped by Holmes. While the board of directors was an impressive gathering of luminaries -- from Henry Kissinger to current Defense Secretary James Mattis -- none of them had a background in the medical field.

The number of times Carreyrou wrote something to the effect of Person X didn't really understand the technology, but Person Y believed in Holmes, and that was good enough was dizzying.

Two of the biggest losers in the debacle were Safeway -- the now-private grocery chain -- and Walgreens Boots Alliance (NASDAQ:WBA). Safeway spent hundreds of millions making new "Wellness Centers" for Theranos' devices in its stores, while Walgreens started using the devices on a limited basis.

But even when a medical professional did give an opinion, it wasn't enough. A Walgreens consultant laid bare the red flags he saw, but a Walgreens executive retorted: "We can't not pursue this. We can't risk a scenario where CVS [Health] has a deal with them in six months and it ends up being real." As Carreyrou later put it, "Walgreens suffered from a severe case of FoMO -- the fear of missing out."

When FoMO is combined with an investment outside one's circle of competence, the results on a portfolio can be disastrous.

3. Diversification is important

Finally, embrace the fact that there's no way to know with 100% certainty if a company is legitimate. Books can be cooked, regulators can be hoodwinked, and accounting shenanigans can hide problems for years.

While hindsight makes reading Bad Blood akin to watching a bad horror movie since we know how it ends -- No, don't open that door with the zombie behind it! -- it doesn't reflect how decisions are made in the real world. Had Holmes never been exposed, those who invested in her might still seem like brilliant investors.

That's why it's important to diversify. Accept the fact that some of your investments will go to zero because of fraud. By doing so, you'll never let any part of your portfolio grow to a point where you'd be ruined if such a scam was revealed.

We're lucky that Theranos never entered the public markets -- although, by doing so, it might have crumbled under scrutiny -- but that doesn't mean we can't learn from it. There's no way to totally eliminate the possibility of fraud from your portfolio. But by checking on the culture, staying within your circle of competence, and staying diversified, you tilt the odds in your favor.

Brian Stoffel has no position in any of the stocks mentioned. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.