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What are we looking for?

Smaller dividend payers weakened by the recent selloff.

While the re-emergence of market volatility was broadly felt in recent weeks, the effect was disproportionate for a couple types of stocks.

First, investors concentrated their fears on small-cap stocks, with the Russell 2000 small-cap index registering a 13-per-cent drop between early July and last Monday. That index has bounced back in the last few trading sessions, but is still almost 10-per-cent off its year-to-date high.

"Small stocks seem to have been indiscriminately sold, and there may be bargains within this group," veteran Wall Street strategist Richard Bernstein said in a recent note.

U.S. small caps also have the benefit of limited exposure to economic forces outside of the United States, which is where renewed fears over growth are focused, Mr. Bernstein said.

Second, dividend stocks were also cheapened as a result of the selloff, especially in comparison to their fixed-income alternatives, as bond yields fell amid the flight to safety.

So, we decided to combine those two possible bargain bins, and look for U.S. small-cap stocks with decent dividend potential.

The screen

First, we limited the search to U.S.-listed stocks, in keeping with Mr. Bernstein's argument that the relative strength of the U.S. economy might offer some protection for domestic small caps. We screened for stocks with a market capitalization of between $100-million (U.S.) and $1-billion.

Next, we set a minimum dividend yield of 2.5 per cent. We also capped the payout ratio, or the proportion of earnings paid out in dividends, at 60 per cent, to leave room for possible dividend increases in the near future.

To try to isolate stocks driven cheaper by the correction, we screened for those at least 15 per cent off their 52-week highs.

And finally, to help identify stocks with decent records of profitability, we screened for a minimum five-year average return on equity of 10 per cent.

What did we find?

The resulting list of 18 U.S. small-cap stocks, most of which are Nasdaq-listed, contains many names likely to be unfamiliar to the average Canadian investor. Further research would be required to determine which among them might represent good, small-cap income stocks at a decent price.

Assessing payout strength among U.S. small caps

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