Being a contrarian investor is seriously a tough gig.
You have to be prepared mentally with the fact that the share price is going to decline further before other investors cotton onto the fact that the stock has been oversold and the share price turns in your favour. That is of course on the proviso that your understanding is correct and the price actually turns.
Too many investors get caught in the mind-set that a low price means value, or in the hope that the price can't go any lower. Before I take on any contrarian position, I remind myself of a famous John Maynard Keynes quote "the market can remain irrational longer than you can remain solvent".
Putting all covenants aside, this is why I believe Rio Tinto Limited (ASX: RIO) may just be a contrarian move worth taking.
After hitting a low of US$37 a tonne last December, iron ore has bounced to a current price of US$54 a tonne. Recent wild price movements have been viewed by many commentators as indicative of weak fundamental support, but I believe the recent volatility has more to do with the market being flooded with short-term speculators.
This point is backed up by the fact that iron ore futures' contracts on the Chinese Dalian Commodity Exchange were recently up an enormous 50 times on the volumes seen in January. Since then Chinese authorities have stepped in to curb speculation and they appear to have succeeded with the price and volumes returning to more sedate levels.
On the fundamental side, I believe a number of green shoots are starting to appear in the Chinese economy and in turn the market for iron ore. Once again house prices in China have started rising, while new housing construction grew close to 20% in the first quarter.
This has had a flow on effect to steel production which has increased to meet this demand and in turn the steel price has risen over 50% since the beginning of the year. While all of this is good news for iron ore suppliers there is little doubt the turnaround has been fuelled by recent fiscal stimulus provided by the Chinese government. So the $64 question is whether this turnaround is self-sustaining or will it falter once government support is removed.
Foolish takeaway
When considering a contrarian stance, I believe it is unwise to go all in. The approach I take is to start with a small stake and continue to monitor how your thesis is evolving. If new evidence supports your original purchase you can then increase your position according to the strength of the new information.
