BHP Billiton has finally given birth to its newest child – South32 – and a potential “baby bonus” to shareholders who received one South32 share for each BHP share held, as a demerger dividend. But should investors hold or sell South32 shares, or buy more?

There is a good case to buy South32 shares, although not yet. Demergers have a habit of underperforming in their first six months as newly listed companies, and South32 has the added complication of a large chunk of shares needing to be bought or sold by index funds.

Expect a bumpy ride in the next few weeks as index funds in the United Kingdom have to sell the shares because South32 is no longer part of the benchmark index they aim to replicate, and as Australian index funds have to buy them to maintain their index exposure.

Retail investors should stand aside from the crossfire: as much as a third of South32 shares could change hands between index funds in the Northern and Southern Hemisphere and it is not clear if index buying will soak up selling.

Another complication is demergers, by their nature, have no history as listed companies and are prone to higher forecasting error from analysts.

As an aside, opportunities might emerge in BHP Billiton. Its market capitalisation should, in theory, fall by the value of the South32 assets being spun off. I’m betting BHP Billiton will fall by a bit less when the volatility subsides because the demerger simplifies the mining giant and makes sense.

The new company

To recap, BHP Billiton spun off a number of non-core base-metal assets in alumina, aluminium, nickel, lead and zinc into South32, which listed on the ASX today as a standalone company (ASX Code: S32). The BHP offshoot inherits 13 assets across three continents.

By commodity, South32 is much more exposed to alumina/aluminium (29% of underlying earnings), manganese ore (21%) and silver/lead/zinc (26%). By country, Australia accounts for 56% of underlying earnings and South Africa constitutes 29%. South America provides the rest.

South32 has one, possibly two, tier-one assets, meaning they are in the lowest quartile on the cost curve — a vital position as commodity prices fall.

Most of the other assets are tier-two, giving South32 a diversified portfolio of mostly base-metal assets that are solid rather than spectacular.

Analysts have pored over South32’s ability to rip costs out of the business and extend mine lives, particularly at Cannington, Australia’s largest silver-producing mine. Retail investors should also consider other criteria when assessing whether South32 deserves a permanent place in their portfolio, or if they should sell their shares, reinvest, or build up cash.

I see three key arguments to hold South32 and buy more if the price dips in the next few months.

1. Demergers

This market has had a huge appetite for Initial Public Offerings (IPO) that bring new businesses to market. But it’s been demergers – the spinning off of assets that are better known to the market – that have provided some of the best returns in the past decade.

Look at the performance of Sydney Airport, spun off from the Macquarie Group in 2009. Or more recently, Recall Holdings, spun off from Brambles in late 2013 and taken over by Iron Mountain this year in a $2.67 billion deal. Amcor spin-off Orora, which demerged in December 2013, has also performed strongly.

Those performances, of course, are no guarantee that other demergers will provide similar returns. But there are good reasons why higher-quality demergers tend to outperform in the long term: as standalone companies, they have greater scope to compete for capital, grow business, cut costs and get a new lease of life from new management.

For investors, demergers have lower information risks than IPOs. Yes, they are still hard to value – look at the wide variations in analyst forecasts for South32 shares – but the market is typically familiar with the assets coming to market, and information on them, subject to ASX Listing Rules over a long period, is often more reliable than that in an IPO prospectus.

BHP also has a good long-record on demergers, having divested BlueScope Steel and OneSteel (later renamed Arrium) to become standalone listed companies. Both have struggled after the 2008-09 Global Financial Crisis, but performed strongly for several years after their demergers.

Another benefit is the parent company having significant reputation risk on demergers. Unlike IPOs that are too often skewed in the vendor’s favour, the parent, at least in theory, aims to unlock value for its shareholders. That South32 comes from BHP Billiton, among the market’s best-governed companies, in my opinion, is some comfort for shareholders.

It is obvious from South32’s structure that BHP has its shareholders in mind. The portfolio has solid assets and the balance sheet has acceptable debt. It is hard to argue that BHP has taken any bit of junk it could find and spun it into a new company for quick gains.

Macquarie Equities research backs up this view on demergers. In an analysis of demergers over the past 20 years, it found the “child” company tends to underperform the market for the first six months, before delivering stronger long-term outperformance.

Should this happen, there could be an opportunity to buy South32 at lower prices in the next 3-6 months, in anticipation of longer-term outperformance.

2. Timing

Another critical question is whether it is time to add more resource-sector exposure to portfolios, given the heavy underperformance of mining stocks in the past three years. Don’t forget that South32 is listing into a backdrop of falling commodity prices and global economic uncertainty.

But valuations are always relative. The rally in interest-rate-sensitive stocks has driven the banks, Australian Real Estate Investment Trusts (AREITs) and utilities collectively beyond value. Yes, there are always opportunities within sectors, but bargains are hard to find.

As the global economy eventually reflates, thanks to unprecedented stimulus from central banks, commodity prices will eventually recover. But the timing and trajectory is uncertain, meaning exposure to a diversified basket of commodities, mostly in base metals, as South32 offers, makes sense.

Conservative investors are better off sticking to BHP Billiton or Rio Tinto. Those with higher risk tolerance can justify a position for South32 in portfolios, provided they can withstand further short-term volatility in resource stocks and hold for three to five years.

By then, today’s resource-stock valuations, for quality companies, could look like a bargain.

3. Scope for organic gains

The third argument for South32 is company specific. There’s little doubt that it can remove significant costs through a leaner structure than the assets had under BHP Billiton, and there is good potential for productivity gains at key mines.

South32’s most important asset, the Worsley Alumina mine in West Australia is a tier-1 asset, and has a long life. But it probably has less scope for cost savings than other mines in the South32 portfolio. Still, it’s a quality asset.

Moreover, the Cannington and MRN bauxite mines have potential for mine-life extensions and higher output.

South32 reportedly has takeover appeal. The media has speculated that a predator could swoop on it after listing: a solid balance sheet, potentially undervalued assets, and scope to buy South32 near the bottom of the commodity-price cycle could appeal to bigger players or large private-equity firms.

I’m not convinced about South32’s takeover prospects in the short term, and investors are always better off buying companies on their fundamentals, not on speculation of corporate deals. Still, the fact South32 is being talked about as a takeover target shows it has come to market in good shape.

Furthermore, South32’s balance sheet provides scope to buy assets, although management seems in no rush. If the commodity rout continues, and more assets have to be sold at fire-sale prices in the next 18 months, South32 has plenty of ammunition to add to its portfolio.

More important is a strong management team and excellent board, led by chairman David Crawford. He copped flak in some quarters for staying on the BHP Billiton board almost 20 years before his retirement as a non-executive director in November 2014, and has polarised critics in the past with his views on proxy advisers and other governance issues. But no director knows BHP Billiton better than Crawford and few in Australia are more experienced or better regarded within boardrooms. His appointment as South32 chair is an asset.

The risks

The main risks to South 32 are continued commodity-price weakness and problems in South Africa. Industrial-relations unrest, sovereign risk and higher energy prices have been a recurring problem for miners there. South32 has five assets in South Africa that contribute almost a third of underlying earnings. Falling commodity prices and rising unemployment in the resource sector should take some steam out of strikes and militant action, but it is a risk to watch.

The verdict

On balance, South32 – which finished at $2.05 on its first day of trading today – warrants a place in portfolios for those who received shares. Short-term weakness in the next six months could present an opportunity for new investors, but there is no compelling reason to buy the shares now, given potential for ongoing volatility after listing for the next few months.

Portfolio investors should watch and wait for better value. Demergers have a knack of getting cheaper before delivering on their promise and outperforming the market. That could be true of South32 in a challenged market for resource stocks.

– Tony Featherstone is a former managing editor of BRW and Shares magazines.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.