IB 1006 Islamic Capital Market
Shariah Stock Screening
Instructor: Prof. Saiful Azhar Rosly, Banking Department, INCEIF
Usually, the stock market serves as a medium where surplus and
deficits units met, thus fueling economic growth from fresh injection
of equity capital. Also, many people make bets in the stock market
making it like their personal casinos. To some extent, when one
invests in the stock market, there are benefits as well as and
disbenefits.
As a way of life, Islam provides rules and guidelines governing the sale
and purchase of equities. However, a systematic understanding of
stocks from Islamic perspective is necessary. This can best be
acquired by first looking at contractual aspects of stock trading. But
we must begin with a brief look at the Shariah before indulging into
the mechanics of legal rulings.
Literally, Shariah is defined as the “path or road leading to the water”
i.e a way to the very source of life. It is God Who is ordaining the Way
where man is to conduct his life, spiritual, mental and physical to
realize His Will. The submission to the Divine Will includes both faith
and practice, from prayer and fasting to legal and social transactions.
When God lays down the law for mankind, it is for a noble purpose.
The objective or intent of the Law/Shariah (maqasid al-Shari’a) is to
preserve five things : the preservation of religion (din), of life (nafs), of
reason(‘aql), of descendants (nasl) and of property (al-mal). For
example in preserving the religion, the five daily prayers (solat) were
made compulsory to the believers (mukallaf). To preserve life,
providing nafaqah (spending on oneself and family) is an obligation on
all married man. To preserve reason, man is enjoined by the Quran to
seek knowledge (‘ilm) while at the same time the Quran forbids the
consumption of intoxicants. To preserve the family, the Quran enjoins
the institution of marriage but condone fornication and adultery.
Finally to protect property, the Shari’ah enjoins man to work (khayr)
for a living while prohibiting wealth creation by way of interest (riba),
fraud (tatfief) and gambling (maysir)
To sum up, the Shari’a is built on two basic principles, namely :the
removal of hardship (ra’f al-haraj) and the prevention of harm (daf’ aldarar). This has direct bearing to the Quranic verse that, “God never
intended to make religion a means of inflicting hardship (22:78) and
“God intends to make easy for you” (4:28). Thus, when the five
necessities (darurah) are well-preserved, man’s attention will not go
into disarray. By disarray we mean, rejection of Divine values ie.
hedonism – ultimate love for wealth and pleasures and the other
rejecting the worldly living ie. denounciation of fitrah.
On this ground, it is important to note that efforts and policies drawn
to conduct Shariah screening on stock portfolios are aimed to preserve
and protect the darurah.
In general, screening stocks along Shariah values can be made in two
ways.
a) First, it deals with the nature of contractual agreement (‘Aqd)
taking place between the issuing company and investors.
b) Secondly, it looks at the nature of production ( ie. Core
Screening) and financial activities ( ie. Financial Screening)
observed by the issuing party.
On the first approach, the trading of stocks in Islam essentially
involves the contract of sale (al-bay’) since what is taking place is the
exchange of assets (shares) for money. A share certificate is an
evidence of one’s ownership of assets. Although the ownership is only
fractional but it gives the owners the right to participate in profit
making, such as determining company policy by way of appointing
company directors.
Thus, at one point, selling and buying of shares is associated with
buying and selling of assets. However, the type of contracts actually
applied in stock trading remains unclear. In the above, the contract of
al-bay’ seems fitting since a share certificate is seen to represent
assets or property (al-mal) that is taking part the production process.
In the contract of al-bay’ the al-mal constitute the subject matter of
contract (mahallul ‘aqdi). But in stock trading, no physical transfer of
assets from the buyer to the seller is evident. In addition, investors do
not really know which particular asset they actually own from the
share purchases.
Also a person who purchases a common stock does not resemble an
ordinary consumer/merchant who buys goods for consumption/
trading purposes respectively. So, using the contract of al-bay’ may
not be an accurate one, to say the least.
Investment in stocks can also be better understood by way of applying
profit-loss sharing principle (PLS). When a company issues a common
stock, it does so to obtain risk or equity capital from the public.
Investors who took up these shares are willing to assume the risk of
losing his capital in a hope to obtain higher returns. Investment in
stocks is therefore a profit-loss sharing activity, which Islam rightly
enjoins.
In share purchases, it seems that the contract of musharakah is more
relevant since it deals with partnership in capital. That is, the
investors and issuing companies constitutes the equity holders and
thus, participated in profit sharing.
When the contract of musharakah is applied in stock investment, the
spirit of cooperation (ta’awun) requires both investors and issuers to
put some degree of commitment in the business ventures. That is,
both parties should stay together during ups and downs. To that
effect, contra-trading seems to go against the musharakah spirit since
this involves exiting the partnership when an opportunity to enjoy a
capital gain is sight.
In this sense, contra-trading has brought some ethical (akhlak)
implications to the musharakah framework. Even though law and
ethics do not mix in legal contract, the contract can become voidable if
it explicitly specifies the special covenants pertaining to exit policy.
In profit creation, Islamic law requires people to participate in risktaking (ghorm). Risk is defined as the variation of outcomes arising
from uncertainty. In Islamic law, two popular the legal maxims
(Qawaid Fiqiah)are most useful as they highlighted the constructive
role of risk-taking in wealth creation, namely: a) No rewards without
risks - “Al-Ghormi bil Ghonm” and b) profits must be accompanied
with liability “Al-Kharaj bil Daman”.
Apart from risk-taking (ghorm), Islamic principles of investment in
stocks require companies to produce goods and services that are free
from the elements prohibited by the Quran. This is where the second
approach to stock screening (also known Core Screening) is applied.
The prohibited goods and services are given as follows:
a. Interest (riba): contractual increase over capital loan
b. Gambling (maisir): speculative or aleatory contracts in
which obligations and benefits accruing to participating
parties are not fully defined at the time when the contract
became effective leading to either wining or losing arising
from mere chance instead of work and effort.
c. Uncertainty (Gharar): uncertainties that exists in
contracts involving contracting parties and the subject
matter, which leads to disputes and unjustified gain
d. Intoxicants (qamar): consumption of alcoholic beverages,
which can impair the intellect (‘aql) leading to irrational
behavior.
e. Consumption of pork
f. Illicit sex (zina) : sexual relation outside marriage which
annihilate the sanctity of the family system (nasl).
However, there are a number of Shariah approved companies whose
activities are not totally shielded from the prohibited elements. To
further filter these companies into the Shariah approved list, the
Shariah Advisory Council’s (SAC) Core Screening have applied
several additional criteria such as:
a) The haram activities must be very small compared with the core
halal activities.
b) The image of the company in the public eye must be good and
well-behaved.
c) The core activities of the company are important to the economy
and considered providing general benefit (maslahah) to the
people.
d) The haram element must be very small and tolerated on the
basis of common plight (umum balwa), custom (‘urf) and rights
of the non-Muslim community acceptable to Islam.
e) The level of contribution of interest income received from
interest-bearing fixed deposits and financial instruments such
as bonds, bills and money market instruments must be less
than 5% of total revenue.
The Shariah Advisory Council (SAC) of the Malaysian Securities
Commission has set up a guideline on Islamic stock investment
bearing the above information. As of November 2008 list shows that
about 80% companies listed on the Bursa Kuala Lumpur are Shariah
approved. This encouraging development saw the launching of the
Kuala Lumpur Shariah Index (KLSI) in August 1998 to help investors
gauge the performance of Shariah-linked counters.
Offshore, the Dow Jones and FTSE Islamic indexes provide a
wholesome approach to the screening process.
Although the two
screening approaches are not identical, both observe two main
screening process:
1. Core Screening: Here a stock is declared permissible (halal)
when the issuing company produces output or products that
are free from the prohibitive elements of riba, gambling,
intoxicants, pork and pornography. Shariah stock screening by
the Securities Commision Malaysia, Dow Jones Islamic Index
and FTSE follows these guidelines well
2. Financial Screening: This screening concerns the financial
activities of the issuing companies.
1. Income derived from reserves and investment securities must
be free from interest. One example is placing reserves in
interest bearing bank deposits.
Permissibility Rule #1 : The ratio (interest income/ total
operating revenue) must be less than 5%.
2. Income receivables must not contain interest (riba). Income
receivables are bills owned by customers who buy on credit,
which the firm expects to collect in a relatively short time.
First the credit sale may require the firm to impute interest
charges due to the delay in payments. Second, firms seeking
loans may use account receivables as a security. This is
known as the assignment of account receivable, in which the
payments and receipts of interest as riba has also taken
place.
Permissibility #2 : (Income receivables / Total asset)
ratio must be less than 45%
The Dow Jones Islamic Index is the most conservative here.
Companies that hold cash and interest bearing securities
exceeding 33% of total assets is excluded from the index.
3. Capital structure of a firm is usually composed of debt and
equity and measured by the debt/equity ratio. Given a debt
equity ratio, one can know the amount of debt the issuer
uses as capital. The bigger the ratio, the more dependent is
the bank on debt financing with the payments and receipts
of interest fully implicated. Full compliance however is not
possible today. Islamic scholars have prepared a cleansing or
purification system in which the impurities say, riba can
avoided by giving it away as charity (sadaqah). In this way,
stockholders will not be directly associated with riba or other
prohibitive elements accompanying the
dividends and
capital gains earned from investments, if any.
Permissibility
Rule
#3:
Leverage
factor,
a
debt/capitalization of less than 33%.