In Defence of Bordeaux

There is a particular sort of flower which is extremely popular and all civilised people find them most attractive.  Flowers can be grown from a seed and the growing process takes around ten years.  The developing plant has little appeal until it blossoms into a flower; it keeps its looks for a number of years then withers away.
 

There is an active market for flowers in their prime.  What people will pay for a flower in full bloom has fluctuated over the years but prices have over the long term risen steadily.  Flowers are a high end consumer item and have therefore unsurprisingly kept pace with inflation.

As a flower enthusiast you always make sure you have several examples in your home, replacing them as they wither.  You have been purchasing flowers for many years and expect to continue to do so in future.  It does not surprise you that the cost of flowers has generally risen over the years since the cost of everything else from a pint of milk to your hand-made shoes has generally risen.  You certainly expect to be paying more for flowers in ten years’ time than you are today.

One day, you are offered some seeds.  These seeds are expected to grow into very nice flowers, perhaps not the very best examples but certainly above average.  They are apparently quite easy to grow: you simply put them in a dark room for ten years and keep them cool.

You consider what you should pay for these seeds.  Flowers of good quality and in full bloom are currently changing hands for around £1,000 each.  If the price of flowers just keeps pace with inflation then in ten years’ time a decent flower in its prime will be changing hands at a minimum of £1,300.

So what would you pay today for something you reckon will be worth £1,300 in ten years’ time?  Ten year interest rates are not so different to the expected level of inflation so when you discount back you just arrive at £1,000.

You reflect that it seems peculiar that you are happy to pay the same price for a seed as you are for a flower in full bloom when the seed can give you no immediate pleasure.  But then something occurs to you:  to insist on paying any less for the seed would be to expect the pleasure and value of a flower in the future to be less in real terms than it is today.  You happily proceed and buy the seeds.

Just then your wine merchant calls offering you an en primeur allocation of one of your favourite clarets.  He tells you it is a very promising vintage and should turn out to be extremely good though perhaps not amongst the very top vintages.  However when he tells the price you are shocked for it is exactly the same as the rather good mature vintage you bought just recently. 

 
You are just about to tell him it is simply ridiculous to ask the same price for a primeur as a mature wine with many years in bottle when you notice the rather lovely flower sitting beside the telephone.  You then look at the seeds you have just bought and after a few moments of reflection you say “Yes, I think I’ll take a few cases of that please”.

En Primeur Motor Cars

Imagine you are a Bentley enthusiast and treat yourself to the newest model every few years.  Every time you go to buy a new one the increase in price gives you a shock; but you accept that the inflation in the price of luxury items seems to have little to do with RPI and more to do with the number of multi-millionaires in the world, so you always go ahead.

 

On one of your trips to the dealer, after you have purchased your latest car, the salesman offers you a deal.  He can offer to deliver you the future prevailing newest model in ten years’ time at the same price as the one you have just bought but you have to pay now.  Given the increases you are used to seeing over the years this looks like a good deal.

 

What if the offer was at a slight premium to the current price?  You might still be tempted since the decision comes down to two factors: firstly, what you expect a new Bentley to cost in ten years’ time and secondly the cost of paying up front – essentially a matter of interest rates.  The point to note here is that you might be perfectly happy to go ahead even if the cost was higher than the price of today’s new car.  In fact, strictly speaking the decision has only a second order connection with the cost of a car today – a new car today cannot be a new car in ten years’ time – there is no arbitrage between the two.

 

So what has all of this got to do with the wine market?  Well the proposition above is essentially an en primeur deal.  Change the Bentley enthusiast to a wine lover.  The new Bentley is now a mature wine which is drinking perfectly.  For example, let us say we like to drink a certain wine which we shall just call Chateau A.  Our wine merchant recommends the 2003 and sells us a parcel for £1000 per case.  This will keep us going for a while but we start to think about how we are going to satisfy our thirst for mature Chateau A further into the future.

 

Our friendly wine merchant has a suggestion:  we can pay him £1000 today and he will deliver to us in ten years’ time a perfectly drinking mature Chateau A.  This will be somewhat different from the 2003 which we are enjoying now - a different “model” if you like – but should be just as delicious.  This wine is of course the 2014 Chateau A.

 

Do we berate the wine merchant and tell him he is trying to rip us off?  How can he possibly charge the same price for a wine which will not be drinkable for 10 years as one which is perfect right now?  If we go back to the Bentley example, we can see that this would be most unfair.  It just does not make sense to compare the two.  They are not fungible.

 

We will be developing this argument in later posts.  We believe there may recently have been too much emphasis on the notion that a primeur “should” be priced significantly under the price of a comparable mature vintage.  Primeurs simply are the mature wines of tomorrow.  Are the commentators and analysts (and the consumers they influence) expecting too much?  Next time you go to buy a new Bentley, tell the dealer you would like to pay him now for the one you will be purchasing in ten years’ time. Then tell him you want to pay him 25% less than what you just paid for the current one.  I wonder what he will say?

The Wine Yield Curve

It is interesting to construct models for the wine market and fit them to market data.  One simple approach is to allow ourselves three parameters with which to determine price - the chateau, the vintage and the critical rating/points.  It is simplest to confine ourselves to the first growths and to come up with a single scaling factor (or multiplier) for each chateau, a single multiplier for each vintage and a non-linear function of the points which provides a quality multiplier for a given score.

 

When we fit this to market the vintage multipliers for 2010 and earlier mainly come out close to 1.  The exceptions are 2000 and 2005 (see later).  For 2011 through 2014 they reduce steadily (down to 0.7 for 2013 and 2014)

 

For 2000 and 2005 the multipliers are well over 1.  In the case of 2005 this is explained by the widely held belief that Robert Parker will significantly upgrade the first growth scores in a reappraisal of the vintage in two months' time.  If this comes to pass, then the prices of the wines will be fully explained by the points alone and a re-fit using the new ratings will result in a vintage multiplier closer to 1.

 

In the case of the 2000 vintage we see elevated demand and relative scarcity pushing prices to a level much higher than one might expect purely on the basis of the points.  This is not simply a matter of age as we do not see this effect in all old and scarce vintages - only ones where the scarcity actually matters.

 

What about the other end of the curve? It is perhaps reasonable that very young wines trade at a much lower price than they will fetch when a little older.  After all, there is still some uncertainty about the quality and how they will evolve.  Moreover the en primeur system means they are very abundant since large quantities are put on the market at one time. 

 

But how much should that "discount" be?  The 2011s are trading on a multiplier of 0.93; the 2012s on 0.84; 2013 and 2014 are on 0.70;  as time passes everything moves up the "curve" - owning young wines is currently (it wasn't a few years ago!) what a financial trader would call a positive carry trade.  The risk is that what you own does not live up to its early promise and at some point gets downgraded. 

 

The 2012s have just been reviewed in bottle and so there is much less uncertainty surrounding those wines.  Assuming no significant re-ratings, over the next couple of years they will outperform by 19% - a chunk of that may of course occur in the next few weeks.  Or buy Mouton 2014 and enjoy a 43% outperformance over the next three years provided it lives up to its barrel rating.  And it would take an enormous downgrade to make purchasing anything else look better in retrospect.

 

Those wine professionals who eschew en primeur as a hard rule did the right thing over the last few years.  But the curve has normalised and they would be wise to reconsider.