The ‘Cockroach Theory’ Raises Investor Jitters

When computer services giant Electronic Data Systems warned last Oct. 23 that its earnings growth was slowing, the news caught Wall Street by surprise--so much so that investors pummeled EDS’ stock down $11.125 to $48.375 that day, a 19% drop.

It’s usually not a great idea to sell into panics, but in this case investors who still own EDS probably wish they had been in the herd rushing for the exit last October: On Thursday, EDS reported sharply lower-than-expected first-quarter earnings and warned that it must take dramatic steps to get profits back on track. Beset by soaring labor costs and intensifying competition in the corporate computer services business, the company said it may fire as many as 10% of its employees.

EDS’ stock plummeted $9.50 to close at $32.50 on Friday, the lowest price since early 1994.

EDS is an example of the “cockroach theory” in action: Many investment pros say they’ve learned over the years that when you suddenly discover one significant problem at a company, more such problems are likely to surface soon--you just can’t see them yet, because they may not even be apparent to the company’s management.

Each time the cockroach theory holds true, investors who ignored the first sign of trouble in a stock naturally become far more skittish about making that mistake again with other stocks. Hence, people’s trigger fingers get itchier; stocks fall faster and harder; and bargain hunters become much more inclined to wait a long time before beginning to nibble at beaten-down stocks.

In a stock market as jittery as the U.S. market today, examples like EDS seem to reverberate more than they deserve to. First-quarter corporate earnings for many companies have, in fact, been far better than expected.

Even so, disappointments on EDS’ scale give people reason to doubt and remind them that after four great years of earnings gains by American companies, the risk of slower growth, and of disappointment in general, is bound to be higher.

The prudent move for many investors thus is to reduce risk by cutting back on potentially overvalued stocks and stocks of companies that are much more vulnerable to the vagaries of their industries, and to stick with the companies that offer relative predictability--exactly why many blue-chip American shares seem to continue to defy gravity.