A Snapshot Of Various Shariah Stock Screening Methodologies

 


25 April, 2019   100 views   Safiudin Ahmad Fuad
Islamic Capital Market Report

Food for Thought

A Snapshot of Various Shariah Stock Screening Methodologies

Safiudin Ahmad Fuad

Brief Profile: Br. Safiudin Ahmad Fuad is a Shariah Management Trainee at the International Shariah Research Academy for Islamic Finance (ISRA). He can be contacted at safiudin@isra.my

Dr. Marjan Muhammad

Brief Profile: Dr. Marjan Muhammad is the Head of Research Quality Assurance at the International Shariah Research Academy for Islamic Finance (ISRA). She can be contacted at marjan@isra.my

 

The first Shariah stock screening was initiated by RHB Unit Trust Management Berhad with the issuance of its Islamic Equity Index in May 1996. Later, in 1999, more indices were introduced to the market with the establishment of the Dow Jones Islamic Market Indices (DJIM) in February, the Kuala Lumpur Shariah Index (KLSI) in April and the FTSE Shariah Global Equity Index (FTSE) in November. But why do we have to conduct stock screening? This article briefly delineates the needs for Shariah stock screening and gives a snapshot of different screening methodologies adopted by some regulators and index providers.

Shariah Stock Screening

Any investment in a company must comply with the Shariah requirements as the ownership of shares of a company constitutes a structured proportionate share of that company’s business and assets. Hence, it is essential to determine the Shariah compliance status of the company before one decides to invest in it. The process of identifying any Shariah non-compliant elements of a company is called stock screening. Investors can invest in companies that fulfill the Shariah stock screening criteria. These screening criteria are applied at the time of the investment decision but also during the ongoing monitoring process to ensure the company remains Shariah compliant throughout the investment period.

Screening Methodologies

Although screening methodologies tend to differ from one entity to another in terms of contents and threshold, generally there are two types of quantitative screening:

  • Sector or business screening: Examines the underlying business of the company to ensure its compliance with the Shariah, hence eliminating any impermissible (haram) activities such as:
    • Riba and excessive gharar; for example, conventional banking and conventional insurance;
    • Gambling such as gaming and casino operations;
    • Manufacturing or selling non-halal products such as pork, liquor, tobacco and related products;
    • Entertainment activities that are impermissible according to Shariah such as  pornography, adult entertainment and nightclubs; and
    • Manufacturing or selling weapons and defence.
  • Financial screening: Identifies the capital structure or source of finance of the company. The screening uses a certain financial ratio to determine the level of company’s Shariah non-compliant financial behaviour, namely:
    • Debt ratio: Debt (or interest-bearing debt) should not exceed 30%, 33% or 33.33% of total assets (or average market cap).
    • Liquidity ratio: Accounts receivable (or accounts receivable + cash or liquid assets) should not exceed 33%, 33.33%, 49%, 50%, or 70% of average market cap or total assets.
    • Interest ratio: Cash + interest-bearing securities (or interest income) should not exceed 30%, 33% or 33.33% of total asset, average market cap or average market value.

Table 1 summarises some activities which are deemed non-permissible for the business screening, and different ratios and levels of tolerence for the financial screening adopted by regulators and index providers in their Shariah screening methodologies.

 

Read Full Article in I-FIKR Digest 12, April 2019 Issue


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