Bottoms-up analysis

(Money Magazine) -- The past few years have been the heyday of "hard assets" - that is, commodities like oil and gas, gold and silver, copper and timber.

Since the end of 2001, the returns on commodities have been three times that of U.S. stocks overall. Investors have been attracted by the ability of hard assets to beat inflation and do well when stocks do poorly.

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But another kind of "alternative" asset has done remarkably well too. A new study shows that you could have outperformed the stock market over the long run by a wide margin if you had invested in the ultimate liquid asset: wine. That's right, vino looks like a value investment.

You may find this result intoxicating, and not just because you enjoy a nice glass of Pinot Noir every now and then. Right now investors are throwing money into hard assets like drunken sailors piling into the only bar in a harbor town.

According to Financial Research Corp., more than $14 billion poured into commodity funds last year. No one seems to be asking the hard questions - or any questions at all - about whether this is a good idea.

Risk? What's that? But sooner or later, in Wall Street's parlance, markets "correct" - witness the Dow's late-February swoon. And when it comes to hard assets, the correction is often sharp enough that even a drunk can feel it. This new research on wine can teach us the importance of sober analysis.

The study, conducted by three finance professors at the University of Wyoming, analyzed eight years of sale prices for fine French Bordeaux at a specialty auction house, the Chicago Wine Co.

They found the same kinds of results that are currently being hyped for hard assets: very high returns (some wines increased in value by as much as 7.5 percent a month) and extremely low correlation to U.S. stocks (when the Dow zigs, Château Margaux zags).

From 1996 through 2003, fine wine generated an annual average return as much as 9.5 percentage points better than U.S. stocks.

Says Lee Sanning, the lead researcher: "Our results suggest that wine assets have strong risk-adjusted performance relative to the overall market."

Gary Boom agrees with Sanning. The delightfully named Boom co-manages what he claims is the world's largest wine investment portfolio, the $92 million Vintage Wine Fund of London (minimum investment: 100,000 euros, or about $132,000). Boom says that fermented grape juice "has outperformed the stock market for 25 years. It has been a holy grail for us."

But Sanning candidly warns that wine is not for everyone. He readily admits that his study, like most academic research, reports returns without taking into account trading or holding expenses. The costs of wine investing are formidable: First, an auctioneer will skim off an average of roughly 19 percent on the buying and 10 percent on the selling price.

So if you buy a bottle for $1,000 and sell it for $1,500, your gain is not $500; commissions will drain your net profit down to only $160 or so. That's not even to mention the cost of building a custom wine cellar (about $50,000 for a decent collection) or insuring your bottles (about $5 a year per $1,000 of value).

And like the little girl who had a little curl, when wine investing is bad it is horrid. Even among the most prized "first growth" wines, losses of 14 percent in a single month are not uncommon. If you want to bail, you might find it tough because this liquid asset often has no liquidity. In some months, many wines never trade at all, and the entire market dries up in spring and summer.

Add it all up (or, more accurately, pour it all out), and the performance numbers are nowhere near as attractive as they sound at first. Wine is for ingesting, not for investing. The pleasure you get out of savoring the taste and aroma of a good bottle may be all you have left after you pay your ownership costs.

And therein lies the real lesson in the new research. Wine experts know not to guzzle the entire glass down as soon as it is poured. But the people who are plunging into mutual funds or exchange-traded funds that specialize in energy or natural resources are too drunk on the raw numbers to think about the net result.

Hard assets go up and down almost purely in tandem with supply and demand. When supply is tight and demand is high, prices soar. But then commodity producers open more mines or dig more oil wells, which floods the market and drives prices back down.

Wine has a supply-and-demand equation too, but it's a little less obvious: People don't suddenly get thirstier, but when the economy is booming, they're happy to spend $100 on a bottle of fine Burgundy, which pushes prices up.

Stocks can also get a bounce from a strong economy, but over the long run their ultimate value is determined by the cash income that company managers generate from the capital that investors have provided. Commodities don't offer that chance for growth, so the only sensible time to buy them is after prices have collapsed, as they did in the mid-1980s and again in the mid-'90s.

The worst possible time is when prices are soaring. Meanwhile, the annual expenses on hard-asset funds can run 10 times the cost of owning a much more diversified, and vastly safer, index fund.

So while permanently keeping a sliver of your portfolio - say, 2 percent or 3 percent - in a commodity fund might make sense as a hedge against runaway inflation, plunging into hard assets now is like paying Bordeaux prices for a bottle of Two Buck Chuck.

History tells us that there are long stretches when hard assets generate very little return: From 1979 through 1998, when the U.S. stock market more than doubled, commodity prices generated an annual average return of minus 0.3 percent.

When today's returns fade, you'll be stuck paying high costs for a hot fund gone cold. (If you lose money on wine, at least you can drink it. But who wants a fund that sits there like a lump of coal?)

Wine is a gastronomic pleasure, but in the real world it does not generate astronomical performance. Likewise, the hot numbers posted by hard assets aren't worth chasing.

The intelligent investor knows that when billions of dollars come gushing into an investment with lousy long-term returns, it's time to look elsewhere for value. And we can all drink to that.

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