The Bordelais are getting it right

Recent en primeur pricing is fair and reasonable when underlying price trends are factored in, argues Watermark Fine Wine’s founder Andrew Davison, who introduces another element to the current en primeur debate.

In this post (original here) we demonstrate that any appraisal of en primeur release prices – indeed any proper understanding of the whole fine wine market – absolutely must incorporate some assumptions on the underlying price trend. You can assume it to be flat if that is what you really believe but to ignore it altogether is flawed mathematics and naïve economics.

But the implications of the argument go well beyond en primeur. A consideration of trend shows some commonly held beliefs to be false. The market has contradicted all these beliefs yet people cling onto them because they seem so reasonable. They say the market is wrong or out of line and must eventually alter to fit in with their view of reality (these people would not last a minute in a hedge fund!) but we will show that when you simply allow for a feature of the market which is entirely in keeping with common sense, and is in any case observable and undeniable, then the perplexing anomalies disappear, the fog rolls away and what comes into view is a market which is more efficient and consistently priced than one ever imagined.

Understanding the price trend

Let us start by thinking about how wine prices move. It is going to be easier to talk about a specific wine but of course everything that follows can be applied to any wine (or indeed a basket). For no better reason than it is one of our favourites, we will choose Chateaux Margaux. Everyone is familiar with graphs which plot the value of a particular vintage of Margaux since release up to the present day but this is not what we want you to think about.

Instead consider the following table:

Price of a ten year old Chateau Margaux as of the year in question

This is a crucially different thing to think about from the price movements of any particular vintage. To try to make the difference really clear, imagine Margaux was divine at age 10 but turned to worthless vinegar at age 11. The table above would still be perfectly feasible but the price of any particular vintage of Margaux would always fall to zero. Or to drive the point home, if we plotted the market price of haddock over the years it would look rather different from a plot of the value of one particular (gradually rotting) haddock!

The reason we are doing this is that we want to see how the value that the world has placed on good mature(ish) Margaux has moved over time. Plotting a single wine is no good since the early data points would show the price of a very young wine and the later data points would reflect the price of an older wine. The shape of the graph could have as much to do with the changing maturity of the underlying wine as with anything else.

Thinking only in terms of “a good 10 year old Margaux” is vital to extracting information from price movements which is actually useful. Some of these wines are a bit better than others but they are close enough in quality to enable meaningful conclusions.

So, do we see any underlying trend? Well it is pretty obvious that we do. But this is hardly surprising is it?  We live in an inflationary world and the price of baked beans, Saville Row suits and haddock has all gone up over time so we would hardly expect the value placed on a glass of good Chateau Margaux to do anything else. Now of course the value of “a good 10 year old Margaux” will move up and down. But what is clear is that the perfectly natural inflationary general upward trend which we would fully expect it to display over time is undeniably present.

This upward trend does not in any way make an investment case for (or against) fine wine. As we have seen with the extreme example of the 11 year old vinegar, buying a particular case of wine can be a terrible investment but the upward trend in the price of drinkable examples will still exist. Trying to make money out of rising haddock prices by buying a haddock does not work!

Utility

The next thing we must look at is the notion of utility – present utility and future utility.

First let’s think about a payment of £1 today and a payment of £1 in ten years. The latter is (assuming interest rates are not negative) worth less than £1. Now imagine a payment in ten years of £1 scaled up by the increase in RPI over the period.  If we expect the rate of inflation to be higher over the ten years than current ten year interest rates we will assign a current value to that payment of more than £1. This may seem an unlikely situation (it is one of negative real interest rates) but it is in fact the situation we find ourselves (in the UK) right now. For the avoidance of doubt, our approach is in no way limited to just the current scenario.

One result of this has been a huge rally in the index linked gilt (“linker”) market. The coupons on a linker are scaled up by RPI and so are dependent on the prices of various goods and services pertaining at some point in the future. Prices of linkers are currently implying that the market predicts the prices of those goods to rise at a rate of about 2.6% per annum. Ignoring the future price appreciation of those goods (i.e. assuming it was going to be 0%) would result in a gross underestimation of the value of these bonds

When inflation exists future utility is a highly prized thing indeed.  Inflation encourages people to get out of cash and invest the money in something which is to some extent correlated with rising prices (has some element index-linking). This is especially true when interest rates are low. A vital characteristic of whatever you invest in is that its utility does not expire in the short term e.g. a haddock. If the upward trend in prices is greater than the interest you forgo by holding it then the assets with their (index linked) utility farthest into the future will be the most valuable. None of this is contentious in financial markets but you may be beginning to see how this is going to blow apart some fallacies of the wine market.

En primeur pricing

So armed with a full appreciation of the underlying trend and perhaps a more flexible view on the relative value of near and far utility let us come back to the wine market.

The thing which most gets in the way of properly appraising en primeurs is viewing them as bottles of wine. When people imagine a tannic 2014 sitting beside a nice bottle of 2004 (or 2006 or whatever seems a reasonable comparison on qualitative terms) they simply cannot contemplate the two being close in price. This is a wholly ridiculous way of looking at it.  It is as if they are somehow alternatives but they are not – they belong to two different time eras and are destined to always remain that way.  Your younger brother will never be the same age as you for as long as you both live.

It may help to simply view the en primeur as a contract – a piece of paper – and then comparisons with mature wines will not seem so tempting.  “Would I rather drink this bottle of 2004 or eat this piece of paper” is not a useful question. An en primeur (any young wine in fact) is simply the right (and obligation) to own a mature wine at some point in the future. It is the value of a mature wine at that point in the future which is the only thing that one should consider when trying to arrive at a fair value for the younger wine.

When I buy 2014 Margaux, I am buying the right to own a 10 year old Margaux in 2024.

Let’s go back to that table:

To assume that a case of ten year old Margaux in 2024 will be £2,750 would be a ludicrously low estimate and would deny the existence of any general price trend – or rather it would say that the long term, entirely reasonable upward inflationary trend is going to stop for ten years. It would be like in the example above refusing to acknowledge that the price of goods in the RPI are going to carry on going up and so concluding that the entire market is stupidly overvaluing index linked bonds.

Of course, we must stress that we are simply interested in the price trend for ten year old Margaux – we are not explicitly interested in RPI which after all relates to the prices of various goods and services none of which is Chateau Margaux. But we can see from the table that “Margaux inflation” exists just as much (indeed more), and for pretty much the same reasons, as baked beans inflation, Savile Row suit inflation or haddock inflation.  Future Margaux inflation may possibly fall more into line with core inflation or it may remain higher but the point is, it exists, it should exist, it makes common sense for it to exist and it is going to carry on existing.

Please remember that the last sentence above is an entirely different statement from one saying that Chateau Margaux prices are going up and it is a going to be a good investment. The second one may or may not be true but it is not a statement about Margaux inflation – remember the vinegar! None of this analysis assumes or denies anything about whether any particular wine or wines will go up or down in price – this is a crucially important distinction.

Let us just take a really conservative estimate for Margaux inflation of 2.5% pa over the next ten years. That would make our best estimate for the price of ten year old Margaux in 2024 equal to £3,520. (Statistical note: we are not saying that this is going to actually be the price of course; this value is our estimate of the mean of the random distribution of possible 2024 values)

The 2014 Margaux is being offered at £2,350. If we buy that primeur, we will need to fund it at say 2% per annum and we will need to pay for it to be stored at say £10 per annum. When it gets to 2024 we will own a ten year old Margaux at an all-in (future) cost of £2,945 – well beneath even the most conservative estimate of what price a ten year old Margaux might then command. The primeur is a compelling buy. Most would say the 2014 is superior to the 2004 which makes it even more compelling.

We can approach it the other way round. If our central estimate for the 2024 price of a ten year old Margaux is £3,520 then under the same interest rate and storage costs, the fair price of the primeur is £2,800. Yes, utterly shocking but that fair price of the primeur is higher than the current price of a ten year old Margaux.

This is simply a perfectly natural result of the underlying price trend being greater than the current level of interest rates even after allowing for storage costs.

With a primeur price of £2,350, the rate of Margaux inflation necessary for it to ultimately have been a good purchase is 0.7% per annum. You are buying Margaux inflation at 0.7% when it has averaged over 6% for the last 26 years.

Beyond primeurs

None of this analysis is restricted to primeurs – it applies quite simply to any two vintages of the same wine of similar quality.  For more expensive wines (where storage cost is a small % of the value) this eventually leads to a full acceptance that younger wines can be similar in price to older ones without any “law of nature” being violated. A young wine is simply a mature one of the future. If we can think of young wines like that and not as tannic liquids in a bottle then their values make so much more sense.

We are not saying that the price of young wines relative to older ones is always about flat. Far from it; the relative value of younger wines to older wines will depend on interest rates, storage costs and trend assumptions. In high interest rate scenarios young wines will indeed be much cheaper; as rates fall they will come in line with mature wines and if rates go so low that they lie under a reasonable estimate of the future price trend of the wine in question, then yes, younger wines will actually be a bit more expensive than mature ones. Buying young wines is like buying long index-linked bonds.

One often reads in wine investment brochures that wine has a “special dynamic”, that because it improves in quality and complexity and scarcity as it gets older it therefore has a built-in tendency to rise in value. Well, you guessed it, this is also essentially nonsense. What these people are saying is that the wine market is full of blockheads who have not worked out that young wines ultimately become old wines.  It is blindingly obvious that if mature wines are valued highly, then so are young wines. Intelligent consumers (and if not, then speculators) will make it so. Of course the general value that people put on wines may go up, but that will apply to all wines and has nothing to do with a special dynamic.

Those same investment advisors talk about older wines currently looking too cheap or young wines being too expensive or that the market is too flat and back vintages must rise to make sense of it all. Actually in the current economic scenario the market makes a lot of sense just as it is. This does not preclude the existence of very highly esteemed vintages – e.g. 1982 – which are difficult to compare to anything in terms of desirability – becoming very expensive. Nor are we saying that there are not some mispriced wines which represent an opportunity – there are indeed many, and several are 2014 primeurs.

Take it further: wines which are deemed to have extremely long lives will be particularly highly valued – remember the preference for assets with utilities as far into the future as possible? The remarkable thing is that in the current interest rate/growth scenario a wine which won’t drink for 50 years but will last for 100 after is perhaps the most highly valued of all – just like ultra-long-dated index linked bonds.

Back to primeurs

We want to get to the reasons why we think this is all so important – especially to the future of en primeur. But before we do let us just look to see what our way of looking at things means for wines in various price brackets.

To keep things as simple as possible we will now take an even more conservative assumption for general Bordeaux inflation of 2%. This and the interest cost are therefore equal and so we are left with the easily applicable rule of thumb that a fair value for a 2014 primeur is just the price of a comparable mature vintage adjusted by the storage cost to bring it to the same maturity.  This will often mean the 2006 or 2008 price less about £60.

This £60 represents a very different % for different price bands; what we get is as follows:

There has been rather too much criticism of wines coming out at “only” 10%-15% under comparable physical vintages.  While the criticism is possibly fair at the cheaper end, in the £500+ bracket that sort of pricing is entirely reasonable. At this point in the cycle it looks attractive. A good example is Leoville Las Cases which at £920 was deemed of questionable value compared to the 2006 which is available at around £1000. We think it is a really good buy. Moreover, the first growth 2014s are incredibly attractively priced. Not just fair, very attractive.

The future of en primeur

The deep discounts for en primeurs in the past was one thing which attracted hordes of speculators to the wine market. (At least part of the whole “investment story” is actually no more than young wines coming into line with a sensible pricing approach. Those investment managers who mistake this for some permanent “special dynamic” are likely to be disappointed in the future). It is not just external speculators either.  Deep discounts tend to get lost in the supply chain as intermediaries quietly hold significant stock back to enjoy the inevitable realignment themselves.

Therefore, any belief that a significant discount approach could ensure a stable future for en primeur is utterly misguided (look at the modest often non-existent discounts which apply in Napa futures). Moreover it is abundantly clear that producers will not contemplate a return to the old way of pricing so it is a non-starter. Yet still some UK merchants cling to the belief that this is how it should be.

Clearly en primeur is in trouble.  For it to have any hope of surviving, a pricing approach must be found which can keep both producers and consumers happy.

In our analysis, we talk about the fair value for a primeur.  Many will say that a primeur price must offer some additional incentive over and above being fair.  If the cost is about the same as one would expect to pay if one just waited then why buy now?  Perhaps, but the following should also be noted:

• There is a big advantage in buying direct from the chateau at the start of the wine’s life. (If one wanted to factor this in to the pricing you would actually use the value of a 2006/2008 case which could be proved to have been unmoved since EP purchase).  This in itself swings the balance towards EP purchases even if prices are merely fair.

• You can bottle it in any format like – this won’t be important to everyone but still a small EP positive

• Do not forget we have been very cautious with trend assumptions so our fair values are already rather conservative

• Buying EP is just a lot of fun and the whole system of allowing you to build tomorrow’s cellar today and look after it yourself is what collectors love about it. Yes, that is beginning to get a bit subjective but surely we are not the only ones who love en primeur simply for the whole experience and who require no more than a fair deal to be enthusiastic supporters

It is this last point which is so important because the future of en primeur is going to rely on the consumer recognising exactly what is and what is not a fair deal.  That is why a properly constructed approach to the subject is so important.  So much of the press commentary is based (mostly unwittingly) on ludicrously harsh assumptions.

Of course even armed with a true fair value the consumer may still decide not to buy even at levels somewhat under that fair value and who are we to argue? As our approach shows, it simply means that they are passing up the opportunity to own, in the future, mature examples of their favourite wines at a real cost which is less than they are happily paying for mature examples today. Who knows – perhaps they all plan to give up drinking!

En primeur 2014 saw a very good Bordeaux vintage released at prices which in terms of how they are positioned viz a viz other vintages of similar quality can be safely viewed as being as low as the producers are willing to go.  We believe that those prices represented, on the whole, a good deal for consumers. Our approach to en primeurs means that there does exist a narrow band in which the price is acceptable to all parties.  If you use the harsh appraisal of other commentators there simply is no such band.

It is only if en primeur prices are set at a fair level that the whole system can survive. The problem with being too high is obvious, but too low and speculators of many varieties come rushing back. Buyers need to look forward not backwards and stop expecting a free lunch. En primeur is a brilliant feature of the Bordeaux market but in terms of price it needs most of all to be one thing: unremarkable.

This article originally appeared on watermarkfinewine.com.