Here’s why you should hold on to your South32 shares

Wondering if you should “stag” your shares in South32? There’s overwhelming evidence that the unwanted child of BHP Billiton Limited (ASX:BHP) will be a keeper.

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I won’t be selling my shares of South32 as this spin-off is one of the reasons I bought into BHP Billiton Limited (ASX: BHP).

In fact, I am expecting South32 to outperform both the market and the parent stock when it first trades on the ASX (on deferred settlement basis) on May 18.

That may shock some, especially given the perception that BHP is venting its “crap” or unwanted assets into this separate entity.

There are two reasons for my optimism or three if you count corporate interest. Firstly, the outlook for the assets that are being dumped into South32 has changed fairly remarkably over the past several months since BHP floated the idea of the demerger.

The spotlight has recently been on how low iron ore could go, when the outlook on commodities that South32 will be producing (such as nickel, aluminium, manganese and silver) has actually stabilised or improved.

South32 will also have scale and enough firepower to undertake acquisitions at a time when assets are cheap. The spin-off, which has an estimated valuation of US$13 billion, will have a very modest net debt of US$675 million.

The tables could also be turned as there are also reports that South32 could be an attractive target for private equity predators.

Former Xstrata chief executive Mick Davis and Western Mining Corporation boss Hugh Morgan have started separate funds to buy resource assets in this down market.

But perhaps the biggest reason to hang on to South32 is because of what history has told us. Demerged entities have a strong tendency to outperform even though investors have often criticised the quality of the assets that the parent company doesn’t want.

Think about the commentary around DuluxGroup Limited (ASX: DLX) when it was carved out of Orica Ltd (ASX: ORI), or Recall Holdings Ltd (ASX: REC) when Brambles Limited (ASX: BXB) was ridding itself from what was seen as an underperforming business.

South32

As the chart above shows, recent notable demerged stocks have performed strongly, although this shouldn’t come as much of a surprise.

A number of research papers have proven that the vast majority of spin-offs have delivered shareholder returns in spades. For instance, Goldman Sachs found that over the last 15 years, the “unwanted” child has produced an average 14% outperformance over the broader market, while the parent entity has generated a 1% outperformance.

However, investors may have to wait a while to see these superior returns. Morgan Stanley found that the real outperformance usually comes between year one and two of the demerger.

Demerger

The spin-off of South32 isn’t a done deal as my colleague Ryan Newman wrote today that the deal has to be voted on by BHP shareholders.  But I think the overwhelming evidence that the demerger is value accretive to shareholders makes this a fait accompli.

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Motley Fool contributor Brendon Lau owns shares in BHP Billiton. Follow me on Twitter - https://twitter.com/brenlau The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.​

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