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In December 2010, I created a screen/hypothetical portfolio called the "High Yield Dividend Champion Portfolio." The screen is tracked publicly as a continuous hypothetical portfolio with a starting balance of $100,000 on Scott's Investments (see the right hand column for a link to the spreadsheet).

Like many of the screens, strategies, and portfolios I track and prefer, this strategy takes a small number of historically relevant ideas, to create a simple, yet powerful action plan for the individual investor. As I have previously detailed,

Some studies have shown that the, highest yielding, low payout stocks perform better over time than stocks with higher payouts and lower yields.

This portfolio attempts to capture the best high yield, low payout stocks with a history of raising dividends. There are numerous ways to gauge the "best" high yield/low payout stocks. The list starts with the "Dividend Champions" as compiled by DRIP Investing. The list is comprised of stocks that have increased their dividend payout for at least 25 consecutive years.

As I detailed in-depth last month, in May I transitioned to a slightly different ranking methodology. The Dividend Champions are still the starting point and we still begin by ranking the top third highest yielding champions. With the remaining high yielding stocks, we will eliminate 50% with the highest payout ratio. The remaining stocks are assigned a rank based on the ratio of their dividend yield to payout ratio. The top 10 stocks based on this ratio make the portfolio. Stocks will be sold at the re-balance date (generally around the 5th of the month) when they drop out of the top 12 (to limit turnover) and are replaced with the next highest rated stock.

I began tracking the portfolio in December and as of July 6th it is up 12.77% including dividends. For July 7th, the portfolio is selling Genuine Parts (NYSE:GPC) because its yield to payout ratio has dropped it out of the top 12. The second sell is Universal (NYSE:UVV) even though it ranks number one on the list.

Looking at this month's list I have significant misgivings about Universal. The company is not projected to have earnings next year and earnings growth was negative this year. Its cash flow from operating activities was less than the dividends paid for the year ending March 31st, 2011. Its status as a Dividend Champion could be in jeopardy, which may explain why it trades at a high yield and low payout ratio (the payout ratio below is not based on projected earnings).

The "system" says it is still a buy but this is a perfect example of when mechanical investing may not give you the complete picture. Thus, we are left with a decision, to modify the system mid-stream or hold steadfast. UVV could still have upside if it can turn operations around; however, the primary objective of this system is investing in stable Dividend Champions with favorable yields and payout ratios. Therefore, going forward stocks that do not have projected forward earnings will be eliminated. Adding this requirement still will not tell the whole picture of any one company, but it could help eliminate fragile stocks and future dividends under extraodinary duress.

The two purchases for this month are MGE Energy (NASDAQ:MGEE) and Sysco (NYSE:SYY).

MGEE

MGEE made a brief appearance in the portfolio for one month in December 2010. As of July 6th, MGEE has a yield of 3.64% and a payout ratio of 56.38%. This utility stock has a low beta of .30 and had cash flow from operating activities of $124 milion last year while paying out $34 million in dividends. It currently trades at a forward P/E of 15, which, if ultimately accurate, is rich for a utility stock. I don't expect significant capital appreciation in the stock at this point, but its dividend appears secure and offers a favorable yield.

SYY

SYY had been in the portfolio for the first six months before being dropped one month ago. This food wholesale company has a yield of 3.32% and payout ratio of 51.7%. It has a forward P/E of 15 and is projected to grow earnings at 7% annually over the next 5 years. Last quarter its cash flow from operating activities was $383 million and it paid $151 million in dividends. Management has generated a return on equity of 28% and return on investments of 15%.

Below are the top 17 stocks for July using the ranking method detailed above (data below as of beginning of the month). Tomorrow I will unveil a strategy on Scott's Investments for adding additional income in conjuction with this High Yield Dividend Champion portfolio. The strategy seeks to enhance portfolio returns via options and will give specific examples of option trades for each stock and potential option trades equity indices to add income.

Data courtesy of Finviz and DRIP Investing.

Company Symbol Yield Payout Yield to Payout Ratio
Universal Corp. UVV 5.10 35.42 14.39%
AT&T Inc. T 5.48 49.00 11.17%
Community Trust Banc. CTBI 4.40 52.59 8.37%
Questar Corp. STR 3.44 42.07 8.19%
Cincinnati Financial CINF 5.48 70.48 7.78%
Consolidated Edison ED 4.51 64.34 7.01%
Johnson & Johnson JNJ 3.43 51.70 6.63%
Kimberly-Clark Corp. KMB 4.21 63.64 6.61%
MGE Energy Inc. MGEE 3.70 56.62 6.54%
WGL Holdings Inc. WGL 4.03 61.75 6.52%
Sysco Corp. SYY 3.34 53.06 6.29%
RPM International Inc. RPM 3.65 60.87 5.99%
Procter & Gamble Co. PG 3.30 55.26 5.98%
Clorox Company CLX 3.56 60.30 5.90%
Genuine Parts Co. GPC 3.31 56.78 5.83%
Northwest Natural Gas NWN 3.86 66.41 5.81%
Abbott Laboratories ABT 3.65 66.90 5.45%
Source: A High Yield Dividend Champion Portfolio for July