What is the Cockroach Theory?
Cockroach theory refers to the notion that unfavorable reports about a company will, once publicized, be followed by similar reports about other companies in the industry.
How Does the Cockroach Theory Work?
Named in reference to the popularly-held belief that the discovery of one cockroach is likely to indicate the presence of others, cockroach theory is the unofficial name for the widely-accepted notion that one piece of bad news about a company will tease out news of similar circumstances surrounding other companies in the respective industry.
For instance, following reports that the Enron was engaging in aggressive accounting practices that did not truthfully reflect their financial well-being, it was revealed that other companies, most notably WorldCom, were engaging in similar practices.
Why Does the Cockroach Theory Matter?
The effects of cockroach theory can have devastating consequences for entire industries because, upon receiving unfavorable news about one company, investors expect similar news about others. Often popular outrage will cause governing authorities to look into other companies. Consequently, investors in the industry in question will be inclined to divest, there will be a drop in the value of a company's stock.