Cockroach Theory: Meaning, Effects, Examples

What Is the Cockroach Theory?

The cockroach theory refers to a market theory that states when a company reveals bad news to the public, many more related, negative events may be revealed in the future. Bad news may come in the form of an earnings miss, a lawsuit, or some other unexpected, negative event. The term cockroach theory comes from the common belief that seeing one cockroach is usually evidence there are many more.

Understanding the Cockroach Theory

The cockroach theory is a nonscientific theory that is predicated on the idea that a company's fortunes are dependent on both external and internal forces, and may not just be affected by one piece of bad news. Put simply, when you see one cockroach, there may be many more you can't see right away. After all, one cockroach usually means there are more lying around in the dark. So when a company is negatively affected by external forces, it is unlikely that its industry peers are immune to those same forces. Therefore, when one company's misfortunes are revealed to the public, it is likely that similar misfortunes will befall other similarly affected companies.

Earnings surprises or misses are indicators of industry trends, particularly if they occur for more than one company in an industry. If one isolated company in a sector shows an earnings surprise, it could be ignored. However, if more than one company announces an earning surprise or miss, it could be a strong indicator that other companies in the industry will have similar earnings results. 

Effects of the Cockroach Theory

Bad news is unavoidable and inevitable—regardless of company or industry. But in many cases, a company's upper management team may try to downplay the effects of any bad news. In fact, some try to turn it around by putting a positive spin on the news even if there's an impact on the company's share price. For some companies, it may be a one-off, but that may not necessarily be the case for others. Wise investors may be able to see through these public relations strategies and understand that a sudden revelation of bad news may lead to something bigger in the future—for the company and even the industry as a whole.

The cockroach theory can have harmful effects on the market. Investors often reconsider their holdings in other companies in the same industry when they're faced with bad news concerning one or more companies in an industry. In some cases, the news is sufficiently negative to convince investors to unload industry stock, which can cause prices across an entire sector to tumble. Moreover, news of impropriety at one company may result in panic and public outcry, which usually ends up piquing the interest of government regulators, who will investigate industry competitors.

Examples of the Cockroach Theory

The cockroach theory has been used to describe several key events in the financial world, namely the accounting scandals that were discovered after Enron, as well as the financial crisis that resulted from the subprime mortgage meltdown.

In October 2001, reports emerged that energy company Enron, which was upheld as a model of success for U.S. corporations, engaged in deceptive accounting practices, misleading investors and the public for years about the company's financial health. By August 2002, Enron was in bankruptcy, and the accounting firm responsible for its audits, Arthur Andersen, surrendered its CPA license. The Enron scandal implied that illegal accounting practices may be more widespread than originally believed, and alerted regulators and the investing public to potential financial misconduct. Over the next 18 months, similar accounting scandals brought down a host of other companies including WorldCom, Tyco, and Adelphia.

In February 2007, subprime lender New Century Financial Corporation faced liquidity concerns as losses arising from bad loans to defaulting subprime borrowers started to emerge. This company was the first of many other subprime lenders that faced financial problems contributing to the subprime mortgage meltdown. In other words, the financial problems of one subprime lender—one cockroach—were an indication that many other similar businesses were in the same position.