August 5, 2024 | Updated | Premium Service | Last month during a trip to wine country, we were confronted by an economic conundrum that is relevant to banks and markets as we prepare for a global equity market reset. After years of suppressed inflation and low quality economic performance, global investors have finally pressed the red button on equity valuations.
So why is the economic situation in wine country relevant to investors? Short answer: inflation. The vast majority of the 500 or so wineries in Sonoma County are small, privately-owned businesses that are not consistently profitable and generally are supported by a sponsor.
Even some of the relatively large wineries that can produce over 1 million bottles annually may not be profitable. Why? The cost of acquiring land and other inputs needed to make wine are simply too costly in the US. Vintage Wine Estates (VWE), one of the largest U.S. wine producers, filed for Chapter 11 bankruptcy last week, citing overexpansion, too much debt and a surplus of grapes as wine drinkers emerging from pandemic lockdowns drank less.
“Grapes are the highest-value fruit crop grown in the U.S., according to the USDA. “Over 70% of the grapes grown are used in wine.” There are more than 3,000 farms in Sonoma County. These farms average less than 200 acres in size and many make a living selling grapes to wineries that are not profitable. The average price of farm land in CA is just over $10,000, but land values in wine country can reach well into six figures per acre depending upon location, varietal type, and historical yields. The inflation in land prices has, in turn, increased operating pressure of wineries. See chart from USDA below.
Source: USDA
One winery we have known for many years, the Martinelli family, has been farming vineyards in California's Russian River Valley and Sonoma County since the late 1880s. Today they own 470 aces of prime vineyards and make stunning Pinot Noirs and Chardonnays. The Martinelli family are sixth-generation wine growers and farmers. They produce about 13,000 cases annually, with 32 different bottlings of Pinot Noir, Chardonnay, Zinfandel, Syrah and old-vine Muscat of Alexandria.
Martinelli Winery, Windsor, CA (July 2024)
Martinelli is very much a for-profit business focused on producing classic wines in an old world style. The single production Pinot Noir like Jackass Hill drink like French burgundy. And yet we were impressed to learn on our last trip that Martinelli sells 90% of their grape production. So is it better to make wine or sell grapes? Remember, contracts to sell grapes are often verbal and pricing can vary depending upon the quality of the grapes each year. Both the buyer and the grower monitor vineyards daily to optimize the timing of the harvest.
We pondered this question of grapes vs wine because it parallels another inquiry, whether it is better to publish an index or operate an exchange-traded fund (ETF). As readers of The Institutional Risk Analyst know, we started publishing the WGA Bank Top Indices in Q1 2024 and have just completed our second rebalancing for Q3 2024. We set the index constituents for Q3 2024 based upon the close on Friday, August 2, 2024. This follows our criteria for defining the test sample of 107 publicly traded commercial banks on Friday at least 30 days after the quarter close.
Over the past year and more, we have looked into the economics of starting an ETF to trade the WGA Bank Top Indices, both from an income and total return strategy perspective. Just as the price of grapes is highly variable depending upon the quality and whether it can be used to make wine, the value of an index is not only based upon its construction, but whether the sector it covers is relevant to investors.
Can we discern good banks from bad? When do we cut the grapes for wine -- or throw them onto the compost pile for next Spring? So far what we have learned is that the exemplars in the top 25 and top 10 banks are far more stable -- and valuable -- than the mediocre middle and bottom of the banking industry. Our observation is that the better performers in the group will continue to excel, but the vast middle of the industry is likely to move lower as credit finally rolls over.
The WGA Bank Top 50 is, well, the top half of the population, but far better in quality than the bottom quartile. In Q3, the top 25 banks had average scores in the 370 range out of a possible score of 535, but the bottom 25 banks in the test group had average scores below 175, a significant deterioration from last quarter. A number of large cap banks fell out of the top 10 after a strong showing in Q2 2024 index test process.
There is also a lot of movement in that top 25 group based upon financial performance and market returns, as shown in the table below for subscribers to the Premium Service. Citigroup (C) fell from 67th in Q2 2024 to 105th in Q3 2024. Axos (AX) ranked 18th in Q3 2024 vs 6th in Q2 2023. Synchrony Financial (SYF) ranked 3rd in Q2 2024 and 11th in Q3 2024. And JPMorganChase (JPM) ranked 2nd in Q2 2024 and 4th in Q3 2024.
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