Loading the player...

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.

RELATED TERMS
  1. Subprime Auto Loan

    A subprime auto loan is approved for people with substandard ...
  2. Subprime Borrower

    A subprime borrower is a person considered to have relatively ...
  3. Entity Theory

    Entity theory is the assumption that the economic activities ...
  4. Enron

    Enron was a U.S. energy-trading and utilities company that perpetuated ...
  5. Mechanism Design Theory

    Mechanism design theory is an economic theory that seeks to study ...
  6. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
Related Articles
  1. Investing

    How Will The Subprime Mess Impact You?

    The subprime collapse could mean doom and gloom for housing, equities and the overall economy.
  2. Insights

    Enron Scandal: The Fall of a Wall Street Darling

    After Enron's management hid financial losses, one of America's largest corporations collapsed, leaving behind employees and investors devastated in its wake.
  3. Trading

    When to short a stock

    Learn how to make money from declining shares by recognizing the signs that show when a stock might be ripe for a fall.
  4. Investing

    How Big Banks Are Slipping Back to Subprime Loans

    Big banks still face risks associated with subprime lending, albeit indirectly.
  5. Insights

    The Fuel That Fed The Subprime Meltdown

    Take a look at the factors that caused this market to flare up and burn out.
  6. Personal Finance

    Subprime Auto Delinquency Rates on the Rise (NICK, CPSS)

    Fitch Ratings reports that delinquency rates for auto loans are nearing 2008 crisis level. What's driving the surge of default? Subprime loans, of course.
  7. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  8. Personal Finance

    Don't Get Trapped by Subprime Credit Cards

    Beware of subprime credit cards. It may be easy credit access, but can take advantage of your poor credit score and eventually catch you in a debt spiral.
RELATED FAQS
  1. What is a liquidity squeeze?

    A liquidity squeeze occurs when a financial event sparks concerns among financial institutions (such as banks) regarding ... Read Answer >>
  2. What is happening during a risk repricing?

    During a strong bull market, the market's overall sense of optimism can often lead to poor estimates about the level of risk ... Read Answer >>
  3. Does the tradeoff model or the pecking order play a greater role in capital budgeting?

    The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital ... Read Answer >>
  4. What is capital structure theory?

    Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise ... Read Answer >>
  5. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
Trading Center