Cockroach Theory: This Is Why Bad News Never Come Alone

The cockroach theory is when a company reveals bad news to the public, but everyone knows that many more related, negative events are to be revealed in the future. The first cockroach is thus just the beginning of an onslaught of bad news: earnings miss, lawsuits, other unexpected, negative events. It comes from the belief that when you see one cockroach, there are probably many more waiting to come out. The same applies to teams, volunteer groups, and individuals. Once one ugly duckling is out there, expect more.

It primarily indicates that more bad news are to come. One piece of evidence uncovers a whole web to be revealed in the foreseeable future. Cockroaches also prompt investigation. When one is spotted — say, a company is caught scamming — a sector-wide analysis could occur where many others get exposed. This is the cockroach theory in effect: one company reveals it’s negative cashflows and, all of a sudden, tens of others appear out of nowhere. It does not always hold in real-world scenarios, though the correlation happens too often to be random. As Warren Buffet said about Wells Fargo in 2017, “There’s never just one cockroach in the kitchen.”

Bad news, by nature, are typically kept secret. So when the problem is revealed, there are typically lots of other problems that the public is not aware of. The tip of the iceberg is small and unsubstantial, but its actual magnitude is submerged beneath the surface. The problem with this theory is that those who are aware of it — investors and economists, generally — can panic unnecessarily. Its a bit of a coin toss really. When a company comes out with the bad, the ugly might come right behind it. Though if it makes us overly cautious, the cockroach does more harm than good.

A real-world example of cockroach theory:

Enron was once a highly regarded energy and commodities company. Now it’s a case study of cockroach theory. The company’s downfall in the early 2000s began with questionable accounting practices. Enron’s issues escalated when it was revealed that the company was hiding debt and inflating its profits. But that’s not all. Remember what grandpa Buffet said? Enron was then further investigated. The analysis revealed widespread accounting fraud, conflicts of interest in leadership, and a lack of transparency in their financial reports. Top executives shred documents during audits. Enron went bankrupt in 2002. The shareholders were wiped out. Employees who were unaware and heavily invested went broke. And this wasn’t the end. The Enron scandal inaugurated an investigation of other companies who were also found dipping their feet in accounting deception. Firms like WorldCom, Tyco, and Adelphia were burned to the ground.

How to use cockroach theory as a mental model: (1) spot the bug — if there’s a standout negative event, anticipate that more are to come; (2) be transparent — if you’re a business leader, you want your shareholders and supporters to be aware of your practices and real data, the cockroach theory being just one of the reasons; (3) be a skeptical optimist — know that bad news may mean there’s more to come, but don’t let this make you overly-cautious; (4) observe your leadership — figure out whether you are working for an organization that’s hiding many cockroaches under its belt, and act how you see fit.