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As Islamic finance becomes ever more prominent and wealth grows in Islamic countries, questions over the validity of a particular investment or financial instrument are also on the rise. Just like with ESG standards in investing, Islamic guidelines on investing in stocks differ between institution, scholars, and mathaheb.
Today, we explore some of the most widely used standards and practices used in screening whether a stock is shariah-compliant, as well as looking at what else is incumbent on the investor to ensure that their returns are compliant.
In Islam, for an investment or financial instrument to be considered “halal” it must meet three crucial conditions:
· 1- The absence of interest or usury (or “Riba”) as it is explicitly forbidden in the religion.
· 2- Usage of the asset as a speculative instrument (or “Gharar”) must be minimized as much as possible.
· 3- One must not use the investment or invest in companies that engage in banned or forbidden activities.
Learn more about: Halal Investment Guide
When it comes to equities investing, these principles aren’t just applied to the trading strategy or financial instrument involved but to the company itself.
These include ensuring that a company’s business activity isn’t involved in forbidden practices, as well as ensuring that its debts, earnings, investments and dividends are as free as possible from the aforementioned practices.
While there isn’t really a comprehensive set of Islamic financial rules and regulations, there are general guidelines developed by leading Islamic finance and accounting institutions and scholars that are followed to determine whether a stock can be considered halal.
According to the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) – which counts a number hedge funds, government entities and central banks among the users of its guidelines for shariah-compliant finance and accounting – for a stock to meet the threshold of halal it must meet the following:
· - The combined value of a company’s revenues from non-halal or “doubtful” sources must be less than 5% of total revenues. These banned business activities include: sale of alcohol and drugs (including nicotine), gambling, trading in pork meat, and any activity that profits from interest.
· - The value of a company’s interest-bearing securities and assets should not exceed 33% of a company’s market capitalization.
· - The value of a company’s interest-bearing liabilities (interest from loans and bonds) should not exceed 33% of the company’s market cap.
Some institutions and Islamic jurists apply further standards to screen against potential “haram” stocks. These include implementing an illiquid assets-to-total asset ratio,
as prescribed by renowned Pakistani Islamic scholar and mufti Mohamed Taqi Usmani. He recommends that a company’s total illiquid assets – assets that cannot be converted to cash quickly – constitute no less than 20% of a company’s total assets.
It is important to note that one must look at how shariah principles apply to a subsidiary of a company. For example: If listed Company A owns a listed bank that profits off of interest,
Company A’s stock is halal if the bank makes up less than 5% of total revenues and that the bank’s balance sheets and income statements do not push Company A’s interest-bearing assets and liabilities beyond the 33% threshold. It is, however, forbidden to buy stocks in the company’s banking subsidiary.
To ensure a company’s stock is above board will require not only knowing all the lines of business activities undertaken by a company but also diving into its financials, including the income statement, balance sheet, and other publicly available investor relations material.
Purification is a key component to “halal” stock investing, especially if there are haram or non-shariah compliant components to a company’s stock. As noted above, for a company to meet its halal threshold,
it is permitted up to 5% of its revenues to be generated from haram. Purification is there to ensure that anything an investor earns from that portion is cleansed through donations and charity.
As with the conditions for halal screening of stocks, there are various guidelines on the purification of income earned from stocks. For instance, there isn’t a single ruling on whether capital gains from the sale of shares will need to be purified.
Some scholars, including Usmani, prefer to avoid the potential risk and rule in favor of purifying capital gains. However, under the ISRA Bloomberg Stock Screening methodology,
there is no need to purify capital gains, as (a) the value of the stock isn’t necessarily directly impacted by the company’s business activities and (b) the change in the value of a stock does not represent interest or any haram activities.
To purify capital gains one needs to calculate the contribution of the suspected activity to the earnings per share and donate that amount, in a manner similar to dividend purification.
One guideline that appears to be unanimous is that purification of dividends is a must. Dividends are the investor’s share of the net profit as distributed by the company to shareholders.
To purify a dividend, an investor must calculate the portion of the payout that comes from non-halal activities and then donate that amount to charity. For example: If Company A pays out a dividend of USD 1.00 per share, and 4% of its revenues comes from haram activities, then an investor must purify USD 0.04 per share.
Read more about: All you need to know about Halal Dividend Investment
The AAOIFI has a convenient methodology that allows investor to calculate the purification on dividends and capital gains on an annualized basis. To do this, you need to determine the component of non-compliant revenue for the company for the financial year.
Divide this by the total number of outstanding shares for the company, then multiply the result with the total number of shares you own in the company.
For example: If Company A earned USD 1,000 in non-halal revenue last year and had 10,000 outstanding shares, the non-compliant revenue per share is USD 0.10. If you held 1,000 shares of Company A, the haram portion of revenue attributable to your shares is 1,000 * USD 0.10 = USD 100.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
