Analyzing wine stocks using Market Elasticity - Brief Article

In the January, 1999 issue of Wines & Vines, we ran the first analysis of publicly-traded wine companies using the Emory Richardson market elasticity model. This model undertakes a quantitative statistical analysis of stock behavior and seeks to predict, over a 3 to 6 month time horizon, how securities will perform relative to the market. The market can be defined in a number of ways: the Dow Jones Industrial Index, the Standard & Poor's 500 Index, etc. For this analysis, the model utilizes the New York Stock Exchange Composite Index.

So how did this model perform based on last year's forecast? The answer is: fairly well. The model essentially predicted that wine stocks would under perform the New York Composite and the S&P 500. As of May 28, 1999 (six months later) only three of the 15 alleged wine stocks were outperforming the index (Fortune Brands, Seagram's and Louis Vuitton).

Since January's article, we have created a chart which better depicts wine stock performance on a risk adjusted basis not only in relation to the index but also in relationship to other stocks. The chart has two axes: the vertical axis represents a measure of return relative to the index and the horizontal axis represents relative risk. The line in the middle (0 on the vertical axis) is the return for the index.

The percentage numbers on the left side of the vertical axis represent excess return. This means that a stock whose performance is estimated to exceed the index by +.4 will have a total return of 65% greater than the market at the end of one year if conditions remain the same.

For example, the graphic indicates that Robert Mondavi Winery (MOND) should have an excess return of about 32%. However, by examining the horizontal axis of the chart, an individual can see that the investment would assume almost 21/2 times the risk of the S&P 500 index to achieve a 32% excess return. Is this a good investment? It all depends on the risk tolerance of the investor and where the investor believes the market is going.

The market elasticity model's basic premise is that three elements influence the price of a security: (1) the impact of buyers and sellers accumulating or selling a stock; (2) the general up and down movement of the market; and (3) the impact of unexplained factors. In a perfect world, stock movement should be explained by the influence of buyers, sellers, and the market. But in our imperfect world, other factors create a dissonance or noise which, in some cases, can overwhelm the influences of buying, selling and the market. Causes of dissonance range from the benign to the extreme with stock manipulation and take-over rumors examples of the latter. The model's ability to identify noise is important because investors are alerted to look to factors other than buying, selling and market forces to explain price movement.

To understand the relative dissonance in the chart of wine stocks, either a triangle, circle, or box appears above each ticker symbol. The triangle denotes that dissonance is a major influence; a circle indicates that the totality of buying/selling market forces are moderately greater than noise; and a box demonstrates that the influences of buying, selling and the market are firmly in control.

Another feature of the model is its ability to gauge the strength of outperformance/underperformance. In each triangle, circle or square, either a minus or plus sign appears. A plus sign means the security's performance is strengthening; a minus sign indicates weakening. The more a stock is influenced by buying, selling and market forces, the greater confidence the model has regarding strength of performance.

Two examples of the strength indicator are Robert Mondavi (MOND) and Louis Vuitton (LVMHY). MOND is demonstrating significant upward performance while LVMHY seems to be running out of steam.

In general, wine stocks do not appear to represent an exciting market segment. For reference, we have plotted Yahoo (YHOO), the S&P 500 index (SPY), and the U.S. Tobacco (UST)-- the last of which could be considered a wine stock. Many of these wine stocks will underperform the market and the noise of unexplained factors is a major influence.

Looking at Geerlings & Wade (GEER), we see it is estimated to outperform the index by more than 60% while assuming four times the index risk. Also, the performance seems to be strengthening. However, its price movement is heavily impacted by dissonance which means this stock is dancing to a tune which cannot be identified by normal buying, selling and market movement. One possible source of this noise is the on-again, off-again merger with Liquid Holdings, Inc.

Whereas GEER demonstrates a high level of dissonance, Golden State (VINT is significantly influenced by buying, selling, and market movement. Unfortunately, all these factors are negative.

Is there a place for wine stocks in a portfolio? For the sake of diversification, the answer is yes. From the chart, several positive candidates are apparent. For short sellers, the opportunities exist but market segments other than wine probably offer better returns.

A closing comment on our universe of wine stocks. Some could argue our choices and omissions. Canandaigua was omitted because of transmission problems from our database supplier; Ravenswood had insufficient trading data. Hopefully, they will be included in the next analysis.

(William R. Wallace has been an observer and participant of the wine industry for over 30 years. He is currently affiliated with a regional brokerage firm in San Francisco and is involved in international Internet trading. Emory Richardson has been affiliated with Boston's Fidelity Management, Wells Fargo Advisors, and Hutchinson Richardson Investment Management, LLC. Recently, he became managing director of Genesis Capital Management, LLC.)

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