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Looking to invest £5k in your ISA? Make sure you avoid this type of value trap!

Here at the Motley Fool, we believe in buying stocks at low prices. That is the fundamental basis of sound investing. This, however, is easier said than done. As my old boss used to say, if it were easy, everyone would do it. 

Why is it difficult? Well, for starters, there are simply not that many companies that are selling cheaply at the minute. The market as a whole is priced slightly higher than the historical average and that average obscures many outliers. Accordingly, there aren’t that many quality stocks that are available for purchase at a great price. There’s no asset so good that you should be willing to pay any price for it. 

But the other side of the coin is that not all cheap stocks are actually good value. Some are value traps – that is, stocks that are selling for a low valuation, and may look attractive for that reason, but that actually have deep systemic issues. In other words, they are cheap stocks where the low price is completely justified

There are many different types of value traps – companies that have high debt loads, incompetent or dishonest management, or obsolete products are all good examples. Today, however, I want to focus on one specific type of value trap that I believe anyone who is investing for retirement should avoid like the plague, and that is companies in declining industries.

What does this mean?

I don’t mean industries that are going through a cyclical downturn, like a national utility during a recessionary period, or an oil company when the price of oil falls. I am referring to sectors that are in irreversible decline. A good historical example of this is the textile industry in the US. 

Everyone knows that Warren Buffett’s conglomerate company is called Berkshire Hathaway, but fewer people know that Berkshire was originally a textile business headquartered in New England. Buffett bought it at a cheap price early on in his career, but by the mid 1970s it was clear that the textile industry as a whole was in decline across the US. To this day, Buffett considers the acquisition of the original Berkshire Hathaway to be one of the biggest mistakes of his career (although he still ended up doing quite well for himself!).

A more recent example of this type of value trap would be the video rental industry, which was virtually wiped out by the emergence of online streaming services. It is difficult to say which sectors will definitely decline in the future – again, if it were easy, everyone would do it – but we can see that some sectors are facing increasing regulatory pressure that may make it difficult for them to expand in the future. An example of this is the tobacco industry, which faces increasingly stiff legislative opposition in the developed world. 

This isn’t to say that you can never make money by investing in declining industries; far from it. But history has shown that doing so can be an uphill battle. Investing is already challenging – why make it more so?

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Neither Stepan nor The Motley Fool UK have a position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.