Shariah Guidelines for Trading and Investment in Stocks
To classify a company as Shariah compliant, the company has to pass the two levels of screening.
Level I – Sector screening
Level II – Financial Ratio screening.
While there is near unanimity among Shariah scholars globally regarding sector screening, there seems to be one major difference on the Financial ratio screening aspect.
The key difference in assessing companies for Financial ratio compliance is the usage of either the Market capitalization or the total assets of the company to compute the ratios. This is the major differing point between Shariah criteria which leads to difference in screening results.
Let us examine the major Shariah criteria in the world and examine what standard they use.
Leading Index Providers
| Market Cap | Total Assets |
|---|---|
| S & P | FTSE |
| Dow Jones | MSCI |
| AAOIFI | KMI-30 (Pakistan) |
| Islamicly | SEC Malaysia |
Islamicly uses the 36 month average market capitalization.
As elaborated by our Shariah Scholars Board, find below an extract of their decision as to why in their opinion market capitalization seems to be a better barometer for assessing the financial ratios of the company:
For publicly listed companies market capitalization provides a more precise value of a company in real-time than book value or assets (Snap-Shot). market capitalization is defined as price multiplied by shares outstanding. Moreover, market capitalization includes goodwill when ascertaining value for the company while book value or assets do not. This is extremely important for economic sectors like technology, with significant intellectual property such as patents, copyrights, and trademarks (Brand name recognition). market capitalization better captures service sectors of the economy like technology, biotechnology, healthcare etc., while book value or assets do not. market capitalization better captures market sector rotations than assets. Thus, market capitalization is dynamic.
Market capitalization is more sensitive to debt-incurring events potentially resulting in downgrades by credit rating agencies.
In cases of debt financed stock buy-back, debt financed acquisitions and increase of debt by issuing bonds, market cap seems to be a better denominator to encompass these corporate actions.
Market capitalization is more transparent and less vulnerable in manipulation, than assets when valuing a company, especially for:
– Small and Mid-Cap companies.
– Emerging-market companies.
However, it must be emphatically asserted, that if a more precise financial measurement tool becomes available for measuring the debt and cash levels of a company, then it must be examined thoroughly and considered seriously for eventual adoption.
Islamicly research has analysed the compliance of stocks using Total assets as well as on Market cap. See the below table for results
| Compliance Changes | 3761 | 24.90% Stocks Changed Compliance |
|---|---|---|
| Turned Compliant | 2032 | 13.45% of the universe became compliant |
| Turned Not Compliant | 1729 | 11.45% of the universe turned non-compliant |
The above table demonstrates that about 25% of stocks would change compliance if the financial ratio compliance would change from Total assets to Market cap and vice versa. Let’s observe the Sector wise analysis of stocks changing compliance:
Turning Compliant
| Sector | % Turning Compliant |
|---|---|
| Construction Services | 14% |
| Electronic Instr. & Controls | 6% |
| Semiconductors | 3% |
| Chemical Manufacturing | 4% |
| Misc. Capital Goods | 4% |
| Oil & Gas Operations | 4% |
| Food Processing | 3% |
| Auto & Truck Parts | 3% |
| Electronic Utilities | 3% |
| Contr. – Supplies & Fixtures | 3% |
| Real Estate Operations | 3% |
| Iron & Steel | 3% |
Turning Non- Compliant
| Sector | % Turning Compliant |
|---|---|
| Biotechnology & Durgs | 19% |
| Software & Programming | 10% |
| Electronic Intr. & Controls | 4% |
| Semiconductors | 6% |
| Computer Services | 5% |
| Business Services | 5% |
| Medical Equipment & Supplies | 4% |
As you can see, modern day listed companies such as Biotechnology and Software services would fail the ratios if they are assessed over total assets criteria as their business models do not require a lot of physical assets.
Islamicly View: It is best to stick to one rule book. Further, there is large consensus on using market capitalization rather than assets in practice as well. Quite a few rule books which earlier used assets, have now shifted to market capitalization. A case in point that market capitalization seems to be a better barometer, is the current COVID-19 induced financial markets crisis. No unusual number of stocks failed the ratios due to the sudden fall in market capitalization.
