Is South32 Ltd a better bet than BHP Billiton Limited?

BHP Billiton Limited (ASX:BHP) might be the 'Big Australian' but South32 Ltd (ASX:S32) might be the better investment.

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Most Australian investors are familiar with the business model and assets of Australia's largest mining company, the $150 billion BHP Billiton Limited (ASX: BHP).

Given how widely owned and followed BHP Billiton is, a reasonable argument could be made that the pricing of the stock is generally efficient and hence there is little chance of it trading at undervalued levels with it most likely trading around fair value most of the time.

A different story for BHP's spin-off

The recent demerger and separate listing of some of BHP's assets into South32 Ltd (ASX: S32) could be a different story however…

Broker CommSec has initiated coverage on the stock with an 'overweight' recommendation and a price target of $3.10. Based on Wednesday's closing price for the stock of $2.15 this suggests significant upside.

It's not actually that surprising that there could be the potential for value in South32's shares. It's quite a common situation with demergers and spin-offs, which for a range of technical reasons may trade over or under true value.

A recent example of the upside which can be achieved from buying into a demerged entity is the Brambles Limited (ASX: BXB) spin-off Recall Holdings Ltd (ASX: REC). Since listing Recall's share price has soared over 70% thanks in part to the emergence of a take-over offer, compared with a near 30% rise in Brambles' share price and a gain of just 8% in the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO).

CommSec cited cost reductions and resource-to-reserve conversion opportunities as amongst the drivers of upside potential for South32, while also highlighting that the company should generate strong cash flows and stands to pay a solid dividend.

Based on CommSec's estimates, the stock is trading on a forecast 2016 fully franked dividend yield of 4.4% and a price-to-earnings ratio of just 12x.

Motley Fool contributor Tim McArthur has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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