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DEFINITION of 'Cockroach Theory'

Cockroach theory is a market theory; it suggests when a company reveals bad news to the public, there may be many more related negative events that have yet to be revealed. The term comes from the common belief that seeing one cockroach is usually evidence that there are many more that remain hidden.

BREAKING DOWN 'Cockroach Theory'

Cockroach theory is predicated on the idea that a company's fortunes do not exist in a vacuum. The forces that put a company in peril are as likely to be external as internal. When a company is affected in a negative way by external forces, it is unlikely that its peers in the industry are impervious to the effects of those forces. Therefore, when one company's misfortunes are revealed to the public, chances are that similar misfortunes are percolating beneath the surface at other companies.

Cockroach Theory at Work

In October 2001, reports emerged that energy company Enron, which had been held up as a model of success for American corporations, had for years been engaging in deceptive accounting practices that misled investors and the public as to the company's financial health. By August 2002, Enron was in bankruptcy, and the accounting firm responsible for its audits, Arthur Andersen, had surrendered its CPA license.

The Enron scandal opened the eyes of regulators and the investing public to the idea that shady accounting practices may be more widespread than originally believed. Sure enough, over the next year and a half, similar accounting scandals brought down a host of 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 fact that one subprime lender (one cockroach) faced financial problems indicated that many other similar businesses were likely to face the same issues.

The Effects of Cockroach Theory

Cockroach theory can have pernicious effects on the market. Faced with bad news about one company in an industry, investors often take a look at their holdings in other companies in the same industry. Sometimes, the news is bad enough to convince investors to unload industry stock, sending prices across the entire industry tumbling. Moreover, news of impropriety at one company can pique the interest of government regulators, which then train a closer eye on its industry competitors.

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