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What are we looking for?

U.S. small capitalization stocks with dividend growth potential.

Recent data show that the pace of dividend growth among larger U.S. stocks is slowing. While payouts are still on the rise on average, dividend reductions by energy and materials companies have cut into the rate of increase.

The negative effect of the commodity slowdown on large cap yield, however, is contrasted by rising dividends among small caps.

According to S&P Dow Jones Indices, the number of companies in the S&P SmallCap 600 index paying dividends has hit a record high, after rising by more than 10 per cent since the end of 2013.

And since dividend growth in particular is so important to income investors, we waded into the pool of U.S. small caps in search of dividend strength.

The screen

We first limited our search to U.S. stocks included in S&P SmallCap 600 index, which identifies companies that are "liquid and financially viable," and which currently have a market capitalization ranging from about $86-million (U.S.) to $4.3-billion.

Next, we looked for current dividend payers, setting a minimum yield of 1.5 per cent, which is slightly higher than the index average.

We also screened for stocks with a recent history of hiking dividends. The three-year average annual dividend growth rate had to be at least 10 per cent.

To help identify stocks with the capacity to raise dividends, we capped payout ratio at 60 per cent.

Free cash flow yield (free cash flow per share divided by share price) had to be positive, which is an indication that the company is generating more cash than is required to keep the business running.

Finally, to screen for companies with proven returns, we set a minimum five-year average return on equity at 8 per cent.

What did we find?

A total of 19 U.S. stocks met all of our criteria, representing past, present and future dividend strength. The energy and materials sectors are virtually absent while financial stocks account for the greatest segment of our list. As always, investors should conduct their own research before making any investment decisions.

U.S. small caps with dividend growth potential

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