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What is 'Cockroach Theory'?

Cockroach theory is a market theory. It posits that when a company reveals bad news to the public, an earnings miss, there may be many more related negative events yet to be revealed. The term comes from the common belief that seeing one cockroach is usually evidence that there are many more.

BREAKING DOWN 'Cockroach Theory'

Cockroach theory is predicated on the idea that a company's fortunes are dependent on both external and internal forces. When a company is affected negatively by external forces, it is unlikely that its industry peers are impervious 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.

Cockroach Theory at Work

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 shows earning surprise or miss, it could be a strong indicator that other companies in the industry will have similar earnings results. 

In October 2001, reports emerged that energy company Enron, which had been upheld as a model of success for U.S. 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 implied that illegal accounting practices might be more widespread than originally believed and alerted regulators and the investing public to potential financial misconduct. 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 financial problems of one subprime lender (one cockroach) was an indication that many other similar businesses were in the same position.

The Effects of Cockroach Theory

Cockroach theory can have pernicious effects on the market. Faced with bad news concerning one company in an industry, investors often reconsider their holdings in other companies in the same industry. In some cases, the news is sufficiently negative to convince investors to unload industry stock, which can causes prices across an entire to tumble. Moreover, news of impropriety at one company can pique the interest of government regulators, who will investigate industry competitors.

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