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Federal Reserve chair Janet Yellen reiterated the distinct likelihood of a December U.S. rate hike last week, causing a jump in North American bond yields and a slide in performance of dividend-paying equity sectors. The potential for a tightening of U.S. monetary policy became more imminent after extraordinarily strong U.S employment data released Friday.

The market action in equities has been well contained so far but for Savita Subramanian, head of U.S. equity and quantitative strategy at Merrill Lynch, the bond market yield fluctuations provided an important reminder that dividend-paying equities underperform significantly in rising interest rate environments. Ms. Subramanian argues that it's time for income investors to "Fed-proof" their portfolios by emphasizing companies most likely to increase their dividends.

The strategist writes, "Unlike high dividend yield, which has historically underperformed when rates are rising as performance is inversely correlated with interest rates, dividend growth has outperformed and is slightly positively correlated with rates."

Merrill Lynch provided three large tables of U.S. stocks that they believe are the most likely candidates for dividend growth. In the accompanying table, I apply a similar screening methodology – emphasizing companies with strong histories of dividend growth, low debt levels and recent profit growth – to find Canadian stocks with the potential to raise their payouts to investors.

The first step in generating the table was to rank all S&P/TSX stocks by five-year dividend growth. Step two was to remove all companies with negative year-over-year earnings growth, on the assumption that companies with slowing profit growth are unlikely to increase their dividend. Stocks removed on this basis included Agrium (the company with the largest payout growth in the past five years), Potash Corp., West Fraser Timber Co. Ltd. and Teck Resources Ltd.

The third step was to kick out all companies for which Bloomberg data indicated that the net debt to shareholder equity was higher than the S&P/TSX composite median value of 47 per cent.

The resulting 20 Canadian stocks presented are an interesting group of candidates for further research. Magna International Inc. tops the list with five-year dividend growth of 53 per cent, no net debt, and year over year profit growth of 28.6 per cent. Linamar Corp., another auto stock, is also represented in the list.

Investors will note that in some cases – CCL Industries Inc. is a good example – the actual dividend yield for the stocks is not inspiring. But that is part of Ms. Subramanian's thesis – the stocks with the current highest yields will be hurt most as the Federal Reserve raises rates. Companies with lower yields, low debt and solid balance sheets have the ability to increase their dividends, and see their stock prices rise along with interest rates.

S&P/TSX composite index stocks

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