It is difficult, if not impossible, to predict when a recession will start or end. Making macroeconomic forecasts is an impossible game that should be avoided.
Therefore, it would be prudent for long-term investors to stress test potential holdings when seeking out high-quality businesses to add to a stock portfolio. Understanding and thinking through how a company will perform in an adverse economic scenario will ensure that you only focus on resilient businesses that do well in any environment.
Let's figure out if RH (RH +0.25%) fits the definition of an all-weather stock.
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Caters to the affluent
RH offers high-end home furnishings primarily through its 68 galleries. These are grandiose showrooms, some of which exceed 30,000 square feet of selling space. The company sells expensive luxury products, so its customers belong in the wealthiest segment of the population. A recession followed by a drop in the stock market or real estate values would cause the net worth of these folks to fall as well, which could potentially hurt RH's demand as discretionary purchases slow.
The pandemic-fueled recession earlier this year was different than a "normal" recession because it was the result of a non-economic shock (the coronavirus pandemic), which ultimately caused most business activity to come to a screeching halt. Although net revenue in first quarter 2020, which ended May 2, was down 19.3% from the prior-year period, RH actually experienced improved business trends week over week from late March through the end of the quarter. Core business demand, which is the dollar value of customer orders placed but not yet delivered, was up in May, June, July, and August from the prior year.
This is interesting because one would think that big ticket purchases, especially lavish home furnishings, would be delayed when economic uncertainty is so high. While Chairman and CEO Gary Friedman certainly believes RH is benefiting from a "COVID-driven shift of spending in favor of the home," he thinks the company's strategy of building a global brand with no peer is just getting started. This is evidenced by RH's second quarter numbers -- the company experienced a record operating margin and profitability.
RH showed its resiliency during what was the sharpest drop in economic activity in recent memory. After being forced to temporarily shutter locations, the business came out stronger on the other end, validating the argument that it is recession-proof. RH will continue thriving, as persistently low interest rates and an accommodative Federal Reserve support asset prices in the foreseeable future.
Financial obligations
In addition to analyzing demand implications, an intelligent investor must also look at how a company's financials may be affected during a recession. As revenue dipped in the first quarter, RH swung to a $3.2 million loss, which was rather impressive given the store closures that happened toward the end of the quarter.
What should have been a devastating three months turned out to only be a speed bump on the road for RH. Given the retail nature of the business, there are substantial liabilities on the balance sheet as well. But these pose no threat to the solvency of the company -- the $549 million of convertible senior notes bear no interest, and the nearly $1 billion in lease liabilities will be honored as RH plans to open new locations wisely in the years ahead.
Protect your portfolio
Similar to Home Depot, RH is benefiting from consumers' restored focus on home improvement and renovation due to stay-at-home orders and freed up spending that would otherwise go toward leisure and entertainment. The difference for RH is that its clientele is wealthy and has more disposable income than the average American household. This provides a floor for the business in times of stress, as we saw earlier this year.
RH's stock is up 73% in what has been a tumultuous 2020, demonstrating its recession-proof status. Investors looking to build an all-weather portfolio should add RH to their watch lists.
