How to Fix a Broken Portfolio

As an investor, you'll often find yourself in situations where you should sell a stock you own. Sometimes, it's because the company's operations fell apart; other times it's because the company no longer fits your strategy. Every once in a while, it's because the company's stock ran up so far so fast that you can no longer justify its valuation.

Any way you slice it, deciding to sell is just as important as deciding to buy. If you're not regularly watching what you own, your portfolio will likely end up broken -- full of investments no longer worth owning. Fortunately, fixing a portfolio once it's broken isn't an impossible task, but it does take a willingness to revisit decisions made a long time ago and see if they still make sense today.

Confessions of a busy dad
Within our own household portfolio, we have one account that we've been neglecting, and it's broken. My wife and I originally set it up when we got married, investing new money every paycheck so that we wouldn't feel the loss of one income when we had kids and shifted to a one-salary lifestyle.

Once we had kids, the regular drumbeat of new investments stopped, and we stopped paying close attention to that account. We did get the occasional dividend payment, and every once in a while we'd reinvest those dividends into another stock. Overall, though, the account just sat there, largely ignored as life happened.

Now, eight years and four kids later, the account is in shambles. Our holdings include remnants from the mortgage bubble, a once-promising biotech that didn't live up to its potential, and a once-fast-growing company whose business may actually have been built on deception. It is in need of repair, and here's how we're going to go about fixing it.

What does success look like?
The first step in fixing a broken portfolio is to understand what a "fixed" portfolio looks like. Where we'd like to get with our account is to own companies with the following characteristics:

• Decent diversification -- somewhere between 10 and 20 holdings, split across different industries. That's enough to keep the failure of any one company or industry from destroying the whole account, while not completely stifling the returns of any spectacular winner.
• Reasonable valuations -- stock prices that can be justified by fundamental earnings power, balance sheet strength, or both.
• Shareholder-friendly dividend practices -- companies with decent histories of paying dividends & raising those payments as the business grows over time. Still, those dividends can't be too high relative to its earnings, or else the underlying company won't retain enough cash to reinvest for its future growth.

That's a fairly high bar, to be sure, but there are thousands of publicly traded companies out there. To repair that account to the way we'd like it to be, we only need to find a few handful worthy of owning. That is a difficult task, but not an impossible one.

Finding those needles in that haystack
By narrowing the universe of potential investments to only the few that hit on all those criteria, the list of potential ones we'd be happy to own narrows considerably. The table below shows some of the survivors:

Source: S&P Capital IQ, as of Nov. 11, 2012. 

With debt-to-equity ratios below 2, they've all kept their debt at manageable levels, signaling healthy balance sheets. They're all trading for less than 20 times next year's anticipated earnings, meaning investors aren't paying outrageous levels for the future. Speaking of that future, all have healthy but not wildly high anticipated growth rates, which outlines the opportunity for the long run.

Perhaps best of all, they've each established a track record of rewarding their shareholders, with:

• Dividend yields above 2%
• Payout ratios in the sweet spot between 1/3 and 2/3 of earnings
• Decent track records of raising those dividends, to provide a decent hedge against inflation.

What's next?
We've identified the type of companies we'd like to own in that account and shown that there are ones available in the market that hit those criteria. Our next step is to sell the ones we currently own there that don't fit.

While there may be some tax consequences from selling, a good rule to remember is to never let the tax tail wag the investing dog. If there's anything worse than paying a little tax to lock in a gain, it's holding on to a company you no longer want to hold -- and then watching the market take away even more.