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The Screening of Stocks for Shariah Compliance

Malaysia was the first Muslim country with a conventional stock market to have come up with a formal evaluation for shariah compliant stocks and a shariah stock index. Following this in 1999, Dow-Jones, the US based publisher of the Wall Street Journal and financial information provider, designed the Dow-Jones Islamic World Market Index (DJIWM). The DJIWM is a global index of shariah compliant stocks. In determining whether a stock is a shariah compliant a screening procedure is used. As we will see below, there is some variance in the filters, used to determine shariah compliance. Shariah screening of listed stocks in Malaysia are based on parameters established by the Securities Commissions, Shariah Advisory Council (SAC). The SAC was established by the Securities Commission (SC) in 1996. The SACs screening process as with the DJIWM begins with looks at two broad categories. These are (i) the line of business or core business of the underlying company and (ii) the companys finances. Essentially, how much interest based borrowing there is in the capital structure and/or how much interest based earnings does the company have.

In examining the line of business, a stock will be deemed ineligible for further filtering if the companys main line of business is a prohibited activity. For example: If its operations are based on riba (interest) such as activities of conventional financial institutions like commercial banks, merchant banks, etc. Operations involving gambling. Activities involving the manufacture and/or sale of haram (forbidden) products such as liquor, pork or meat not slaughtered according to Islam. (iv) Activities containing an element of gharar (uncertainty), such as conventional insurance. While it is easy to identify and eliminate companies involved in obviously haram activities the challenge lies in evaluating companies that have mixed activities. These are companies that have some portion of their business in forbidden activities. It used to be, that fuqaha would automatically disallow investment in such stock. However, given contemporary realities, shariah scholars agree that such companies should be considered. As such, the SAC applies several additional criteria for such companies; these being: The core activity must not be one that is forbidden (the four criteria above). In addition, the haram element must be very small relative to the main line of business. The public perception or image of the company must be good. The core activities of the company have importance and maslahah (benefit in general), the haram element besides being small involves matters such as umum balwa (common plight), uruf (custom) and involves the rights of the non-Muslim community which is accepted by Islam.

While the above criteria are all subjective, in order to translate these subjective criteria into actionable filters, the SAC uses a two phase analysis/screening procedure. These being:

(a) Phase One: Quantitative Method (b) Phase Two: Qualitative Method

Phase One: Quantitative Method In phase one, the objective is to compute the percentage contribution of non permissible activities to the companys income and profit before tax. The income and profit before tax would be for the latest fiscal year as shown in the companys Profit & Loss or Income Statement. The computation of percentage is carried out as follows:

Step 1: Determine the earnings (Total Income/Revenue) and Profit before tax of the company. Step 2: Identify and measure the income/earnings and profit before tax from the non permissible activities.

The SAC has determined two threshold level marks. These are: 5% threshold level mark: Companies whose earnings and/or profit before tax from non permissible activities is more than 5% will have their stocks excluded from the list of shariah compliant stocks. One should take note that this 5% threshold is only valid where non-halal earnings are clearly identifiable and measurable. For example, if a manufacturer of jewellery has more than 5% interest earnings from its deposits, it will be excluded. Similarly, if an airline has more than 5% of its earnings from duty-free sale of liquor its stocks will also be excluded. In both these cases, the non-halal activities are easily identifiable and measurable.

But what do we do in cases where the non permissible activities cannot be identified and its contribution to earnings and profits are therefore not measurable. The classic case that is often cited as an example of this, would be that of hotels and resorts. How can we enumerate the contribution of non-halal activities to the earnings/profits of a hotel chain? For example, the Shangri-La Group or Hilton International, both of which operate hotels and resorts in many countries. It is to handle situations like this, that there is the second threshold level. 25% threshold level mark for image. For example, suppose a conglomerate involved in halal activities, has a hotel subsidiary. The hotel industry has a perception problem, if the earnings/profits before tax of the hotel subsidiary is less than 25% of the conglomerates earnings or PBT than the conglomerates stock would be deemed shariah compliant. If however, the contribution is more than 25% than the shares will be excluded.

Phase Two: Qualitative Method The qualitative method is essentially used on a case-by-case method. Again this is applicable for situations where the core activity of the company has importance and maslahah (benefit in general) to the ummah but includes a small element that may be haram. The non permissible activity could also be driven by custom or involve the rights of nonmuslims. In analyzing such companies on a case-by-case basis, the SAC allows for threshold levels anywhere from 10% to 25%. Since businesses are dynamic and conditions change rapidly, a company that passes the threshold at a point in time may exceed it at a future date. For example, a manufacturer of home appliances may have interest earnings below 5% currently but could exceed it at a later point. The opposite situation may also be possible. Thus, the SAC reviews the list periodically. An updated list is issued every 6 months. Currently about 85% of the listed stocks in Malaysia are deemed shariah compliant, based on the SAC criteria.

Stock Screening for the Dow Jones Islamic Index In many ways the stock screening procedures used by Dow Jones for its Islamic Index is more elaborate and tighter than that of Malaysias SAC. As is the case with the Malaysian criteria, there are two broad categories, the nature of the business and financial aspects. The Dow Jones criteria is much more stringent where a companys financial aspects are concerned. In fact, while the Malaysian evaluation does not look at a companys Balance Sheet, only its income statement, the Dow Jones criteria involves both financial statements, especially the Balance Sheet. Dow Jones begins with an initial step that involves eliminating stocks of all companies involved in an exhaustive list of activities. These are industries related to alcohol, liquor, pork related, conventional financial services (banking, insurance, merchant banking etc), hotels, entertainment (including cinema, music etc), tobacco, defense, weapons manufacturing etc. While this first step is qualitative, the second step involves the quantitative analysis of the firms financial ratios. This numerical analysis is really aimed at two things: (a) identify firms with excessive leverage in the capital structure and (b) identify firms with unacceptable levels of interest income. This is generally done by applying the following three key ratios:

(ii) Debt to Trailing Twelve Month Average Market Capitalization (Debt to TTMAMC)

Comparison of Stock Screening Techniques Though the philosophy and intended objective is the same, a comparison of the stock screening techniques of the Dow Jones Islamic Index (DJII) with that of the Malaysian SAC pints to obvious differences. The two key differences are: The tolerance for mixed businesses by the SAC. The more stringent use of Balance Sheet based financial ratios by Dow Jones. Recall that Malaysias SAC allows for the inclusion of non-halal business as long as the contribution to earnings and profit before tax is no larger than 5%. In the case of DJII, there is no such allowance. If any part of a firms business is in a prohibited industry, the firm is automatically dropped. Malaysias SAC also does not evaluate a firms Balance

Sheet. Thus, the firms capital structure and the extent of its financial leverage is not a consideration. It is obvious that relative to Dow Jones, the Malaysian criteria is a more liberal one. This difference has more to do with economic realities than anything else. While the Malaysian criteria is intended to be country specific, with Malaysian listed stocks the main target, there is no such restriction where the DJII is concerned. Any listed stock in a tradable market is a potential stock where Dow Jones is concerned. Thus, for Dow Jones, it is a global universe of potential stocks. Given a much larger investible set of stocks one can be stringent and still be able to identify a sufficiently large number of shariah compliant stocks. Since the SACs criteria is Malaysia specific, using a stringent filter will result in a smaller group of eligible stocks and therefore a much narrower investible spectrum for Muslim investors in Malaysia. One might ask, what is wrong with having a smaller but purer group of investible stocks? There are several problems with this: First, from a portfolio theory viewpoint, a smaller investible group of stocks restricts diversification and limits the benefits of diversification. Second, one cannot form efficient portfolios or superior risk-return portfolios if the group of investible stocks is restricted. Finally, by implication one cannot be on the optimal efficient frontier or get close to such a frontier. The net result would be portfolios that may be purer but not necessarily efficient from a risk-return viewpoint. Thus, stringency in stock screening is not costless. As with everything else in economics, there is a trade off. The cost may be less efficient portfolios .