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GameStop: Boy is it cheap. But boy is it in a bad business.

“The only Western investors to make a dollar out of China were the 1900s opium traders, and they had the royal navy behind them,” said Jim Chanos today, recounting a comment he heard a couple months back. “I’d venture to say if you need the Royal Navy behind you,” said Chanos, “it’s not a value stock.”

Chanos spoke about “value traps” – doomed sectors and companies that look cheap to investors – at the Value Investing Congress, outlining common characteristics of short-selling situations and areas for long-term investors to avoid. Chanos highlighted themes that have ensnared value investors in the past and referenced a number of companies that look cheap, but don’t actually offer value to investors.

Jim Chanos’ Value Traps

Liquidating Trusts

The first value trap highlighted by Chanos is the area of liquidating trusts, particularly integrated oil companies. Oil exploration, development and production has increased in price at an amazing pace. Finding and developing a barrel of oil cost $5 in 2000; now it costs $22. Production costs have risen from $5/barrel to $15/barrel in the same time period.

Not only that, but governments in Brazil, Russia, and US have hindered development of oil resources, while natural gas has emerged and grown. As IOCs move to natural gas production, the price of gas plummets, due to what Chanos called “uneconomical” development. In particular, Chanos highlighted ExxonMobil as a potential value trap, pointing to a reserve replacement ratio that was inflated by the company’s acquisition of XTO. Exxon had $25 billion in net cash at the end of Q4 2007. Now, just 14 quarters later, it has net debt of $6 billion.

Analog To Digital Distribution

Analog media across the board has continued to march toward the digital age, and Chanos still see value traps on the horizon. Music companies have taken huge hits, and video game rental companies like Blockbuster have followed suit. Next up? Chanos think Gamestop is at risk.

“It is cheap,” he said. “Boy is it cheap. But boy is it in a bad business.” As more games move to digital, prices fall, margins shrink, competition increases and Gamestop’s trade-in used game marketplace flounders.

“This is one you’re going to think is cheap all the way down,” said Chanos.