Step four: the financial screening of conventional stock

June 15, 2012 8:19 am

By Kaushiq Kodithodika, Advent

Lists of acceptable stocks are supplied by various index providers, although not all may be universally accepted by Shariah experts. Obviously excluded are stocks in companies that deal with alcohol (and often tobacco), gambling activities, pork and arms manufacturing.

Some investors may prefer to avoid investing in airlines, hotels or supermarket chains that serve or sell alcohol, even though this is a minor part of their business. This would, however, result in a much more restricted potential portfolio selection. Therefore, businesses are usually defined by their primary activity. This principle may make a hotel group acceptable, but a brewery unacceptable. There are parallels with ethical investment funds that avoid investing in tobacco companies but may invest in retailers selling cigarettes alongside other items.

While there is no universal consensus among Shariah scholars on the prohibition of tobacco companies and the defence industry, most boards advise against investment in these activities. Investment in conventional interest-based financial institutions is also non-permissible. Insurance companies are excluded for this reason,and also because the concept of conventional insurance itself is not wholly accepted.

Generally, it would be desirable to avoid investing in companies that have any involvement at all with interest (riba) or riba-based banks. However, this would mean the exclusion of virtually all quoted companies, including those that have their stocks traded in the equity markets of Muslim countries.

Additionally, most Islamic scholars accept that modern corporate capital structures of conventional corporations inevitably include some debt on the balance sheet and fixed-income liabilities. As a result of this pragmatic thinking, investments in companies that have low interest income and below average debt-to-equity ratios have been declared acceptable by various Shariah advisory boards, often with the provision that profits must be “purified”.

However, Islamic scholars differ in defining an acceptable debt-to capital ratio. In practice, investors seeking to comply with Shariah principles adopt several criteria:

– The extent to which a company’s income is derived from interest, generally any proportion in excess of 5% being unacceptable;
– The extent of debt-to-equity finance, a proportion in excess of one-third generally being unacceptable.

Positive criteria can also be used to pick acceptable stocks, such as companies with pro-environmental policies or ones that support their communities or provide humanitarian services. A helpful tool is provided by index specialists through widespread screening of conventional stocks listed on major exchanges. The prominent index providers each offer their own Islamic indexes such as the FTSE Shariah Global Equity Index Series, the Dow Jones Islamic Market (DJIM) Indexes, S&P Islamic Indexes and the MSCI Islamic Indexes.