As a child, my greatest fear was Katsaridaphobia. No, it is not a fear of an illusionary monster hiding under the bed or the fear of heights.
It was the fear of cockroaches which prevented me from doing a lot of things such as walking near drains or opening kitchen cabinets where I had spotted cockroaches before.
Although I have long overcome the fear of cockroaches, I still hate them to the core. They are not only disease transmitters but also challenging to eradicate given their adaptability to survive even in extreme conditions.
But the worst part is their ability to multiply at an alarming rate. Which means if you see one around, it probably means just the tip of an iceberg. The chances of a few hundred cockroaches somewhere nearby is very high.
Stock markets too have a connection with cockroaches. It is called the cockroach theory of investing.
Cockroach Theory In The Parlance Of Stock Market Investing
Just like spotting a single cockroach means there are many more cockroaches around, the cockroach theory in investing states that when a company reveals bad news to the public, many more related, adverse events may be revealed in the future. Negative news could be in the form of missed earnings, a lawsuit, or some other unexpected, undesirable event.
Further, the theory states that the situation could affect both companies as well as sectors. As investors may reconsider other holdings in the same industry because of bad news, the cockroach theory tends to have an adverse effect on the overall market.
The best example of this is the IL&FS crisis of 2018
I am sure you might have heard and read about it a lot over the last two years. Let's take a look at how the IL&FS crisis serves as the best example of the cockroach theory in investing.
Somewhere around the 10th anniversary of the collapse of Lehman Brothers which led to the global financial crisis in September 2008, India's leading infrastructure finance company, Infrastructure Leasing & Finance Services (IL&FS) defaulted on payments to lenders triggering panic in the markets.
IL&FS is the holding company of the IL&FS Group, which comprises of several companies with expertise across infrastructure, finance and social and environmental services and has several institutional shareholders like LIC, HDFC, SBI, CBI etc.
The first cockroach in this case…
As a result of failure on the part of IL&FS Financial Services in meeting its payment obligations of bank loans (including interest), term deposits and commercial paper redemption obligations due on 14th September 2018; the company reported that it had received several notices for delays and defaults the next day.
The second cockroach….
Post the defaults, rating agency ICRA downgraded the ratings of IL&FS’s short-term and long-term borrowing programmes as it meant that the defaults also put at risk the money of investors, banks and mutual funds associated with IL&FS.
The third cockroach….
The defaults sparked panic among equity investors who started dumping stocks of non-banking financial companies (NBFC) on a large scale. Market sentiment turned negative for non-banking financial companies with even share prices of fundamentally sound companies like Bajaj Finance taking a big hit.
The other cockroaches…
The spillover effect of correction in NBFC stocks was also witnessed in other sectors with an overall market sentiment turning bearish. As a result, the benchmark index BSE Sensex corrected from a high of 38,934.35 in Sept 2018 to a low of 33,291.58 in Oct 2018 after the IL&FS crisis came to light. Over the next few months markets were very volatile and only in Mar 2019, Sensex could reach near its Sept 2018 levels.
Important takeaways from the cockroach theory in stock market investing
The cockroach theory in investing is based on a simple fact - that a company's fortunes are dependent on both external and internal forces. In simple terms just like when you see one cockroach, there are likely to be many more unseen cockroaches around. When a company is negatively affected by external forces, it is unlikely that its competitors will remain unaffected. Consider the case of the telecom sector in India. Just a few years back there were as many as nine private sector telecom operators in India. Today there are only three companies; Reliance Jio Ltd, Bharti Airtel Ltd. and Vodafone Idea Ltd. While Vodafone Idea is struggling to stay afloat, Reliance Jio and Bharti Airtel have managed to hold their fort by eliminating their debt and fresh capital infusion. In case you wish to read more about it, check out our earlier articles on Vodfone Idea here and Bharti Airtel here.
A dip in earnings, especially for more than one company in a particular sector is a matter of concern.
External forces can affect any company or industry. Still, an investor should be extra-cautious if the company's management team is trying to downplay the effects of any bad news, to avoid falling into value traps. Remember Yes Bank?
The best way to eliminate cockroaches at our homes is to restrict their access to food and water. Despite this, if the infestation goes out of hand, it is time to seek expert help.
Similarly, the best way to get rid of cockroaches in the stock market is to invest in good quality stocks for long term, properly diversify your portfolio, and reduce over-exposure to a particular stock or sector. Discover how you can create a winning stock portfolio.
And don't hesitate to seek expert help before things go haywire.