Defining Cockroach Theory

The cockroach theory refers to the observation that unexpected negative news about a company revealed to the public may be an indicator of many such negative news to be revealed in the future. This theory is named after a common observation that a presence of one cockroach in a home or kitchen is often an indication of many more hidden.

This theory states that a piece of bad news of the company in the Market indicated the possibility of more bad information. Also, if one bad news about a company in the sector is revealed to the public, other companies in that same sector are likely to encounter similar problems.

Cockroach theory is generally used to warn investors about the likelihood of bigger problems from companies that often may not be transparent in their reporting to investors.

Warren Buffett once said “In the world of business, bad news often surfaces serially: you see a cockroach in your kitchen; as the days go by, you meet his relatives.”

The Effect of Cockroach Theory

It is a theory that states the situation not only about a company, but the whole Industry, which helps investors to rethink about their holdings in the same sector/ industry. One bad news can have a negative effect on the market as a whole. Moreover, such news creates panic in public.

The cockroach theory can have harmful effects on the market. In some cases, the news is sufficiently bad to convince investors to hold the stock, which can affect the share prices across an entire sector.

The sighting of a cockroach, meaning bad news in the industry, is like an early indicator of a trend reversal. This means that trend is reverting to its long-term mean.

Example

The Enron scandal is one such example of Cockroach theory. In 2001, reports emerged that the energy company Enron engaged in deceptive Accounting practices, misleading investors and the public for years about the financial health of the company. In August 2002, the company filed for Bankruptcy and the accounting firm responsible for its audits, Arthur Andersen, renounced 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 malpractices & sandals brought down a number of other companies, including Tyco, WorldCom, and Adelphia.