what shariah says about equity investments

7/27/2019 What Shariah Says About Equity Investments

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What Shariah Says

About

Equity Investment?

Sa b a A k h l a q u e K h a n D i r e ct o r I n v e st m e n t s

S a b a .k h a n@g u a r d i a n s e c u r i t i e s .c om . p k Fe b r u a r y 0 4 , 2 0 1 0



G G G U U U AAA R R R D D D I I I AAA N N N

R R R E E E S S S E E E AAA R R R C C C H H H S h a r i ah – Com p l i a n t Eq u i t y I n v e s t m e n t

Guardian Securities (Pvt.) Limited Ph # 042- 35870282 E-mail: [email protected] 2

I n t h e n a m e o f A l l ah , t h e m o s t m e r c i f u l a n d b e n e f i c e n t

T h e H o l y Q u r a n Sa y s :

“ A n d f e a r t h e D ay w h e n y o u s h a l l b e r e t u r n e d t o t h e Lo r d

a n d e v e r y s o u l sh a l l b e p a i d in f u l l w h a t i t h a s ea r n e d a n d

n o o n e sh a l l b e w r o n g e d .”

( S u r a h a l - B aq a r a h , V e r s e : 2 8 1 )






T a b l e o f Co n t e n t s

Co n t e n t s P a g e #

The Perception of Equity Investment 4

Prohibited Transactions in Shariah 5

Stocks Selection & Purification Methodology 6

1. Industry Screen 7

2. Securit y Screen 7

a. Analytical Review of Security Screen 7

1. Total Interest bearing debt / Total Assets 8

2. Interest – based Assets / Total Assets 8

3. illiquid Assets / Total Assets 8

Purification of Earnings 9

a. What Shariah Standards Say 9

b. The Present-day Common Practice 9

c. Purification of Capital Gain or Not? 10

Appl ication of Screening on Securi ties Listed at Karachi Stock Exchange 10

a. Shariah – Compliant Stocks 11

b. Shariah Non – Compliant Stocks 12

Conclusion 12

Glossary Used 13

References 13






The Perception of Equity Investment

We the Muslim Ummah are blessed with the best ever chosen religion of the world. Therefore, it is the utmos

responsibility of the whole nation to carry out all those activities in life which have been portrayed by the Holy Quran and

the Sunnah. In today’s highly developed world, we are much more stressed to meet our basic necessities and if we

succeed to save some amount of money, we want to invest it in any lucrative business. But it is necessary that these

investment opportunities must be free from unlawful / interest-based activities.

The Holy Quran reveals in Surah al-Baqarah:

"Those who benefit from interest shall be raised like those who have been driven to madness by the touch of the

Devil; this is because they say: "Trade is like interest" while God has permitted trade and forbidden interest

Hence those who have received the admonition (warning) from their Lord and desist (discontinue) may keep their

previous gains, their case being entrusted to God; but those who revert shall be the inhabitants of the fire and

abide therein for ever." (Verse: 275)

The vast majority of Shariah Scholars are in agreement that investment in stocks is allowed. But it must be complied with

the Shariah parameters. For that purpose a screening process for the selection of shares must be followed.

During my career (being a Research Analyst & Investment Advisor) at the stock exchange, I found few investors who

followed the Shariah norms by avoiding to take financing and denying to invest in conventional banks and insurance

companies’ stocks as well. I used to appreciate them but after getting ‘Certification in Islamic Banking’, I came to know

that staying away from non-compliant stocks is not enough to make permissible investment. For instance, a company is

carrying a Halal (lawful) business like Textile, Cement, Automobiles etc, and keeps its surplus funds in an interest -

bearing investment or borrows interest based funds from financial institutions, which results in some complementary

interest proceeds in its business operations. But important point is that any minor interest element does not convert the

whole Halal business into Haram (unlawful). That’s why, Shariah Advisors have formulated a set of filters through which

the trading of shares is permitted, upto a certain tolerance level, with the condition that investors have to purify tha

proportion of non-permissible income by giving it to the charity.

The Allah Almighty Says:

“ God deprives interest of all blessing, but blesses charity; He loves not the ungrateful sinner.”

(Surah al-Baqarah: 276






The prime purpose for writing this research paper is to evoke the awareness about the Shariah norms of investment to a

the concerned persons of the stock market and enable them to filter their Investment Portfolios by conducting screening

practice themselves. To accomplish this motive, I strived much to find out the authenticity of methodology for the selectionand purification of stocks by means of comprehensive study of Shariah Standard -21 (AAOIFI) and analyzing the following

Islamic Indexes and their methodologies:

♦ KSE Meezan Index

♦ Dow Jones Islamic Market Indexes

♦ MSCI Global Islamic Indices

♦ Standard & Poor’s Shariah Indices

♦ Screening Cri teria of SEC, Malaysia

♦ Screening Criteria of Dubai Islamic Bank

♦ Screening Norms of National Commercial Bank, Saudi Arabia

Prohibi ted Transactions in Shariah

♦ It is not permissible to acquire the shares of the companies providing financial services on interest, like

conventional banks, insurance companies, or the companies involved in some other business not approved by

the Shariah, e.g. companies manufacturing, selling or offering Tobacco, liquor, pork, haram meat, or involved in

gambling, night club activities, pornography, prostitution. These activities have negative impact on the society.

♦ The Prophet (Peace be upon Him) , in addition to prohibiting gambling (games of chance), also prohibitedBay

al-Gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty). Ibn

Hazm of the Zahiri School wrote "Gharar is where the buyer does not know what he bought, or the seller does

not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the

sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the

trade similar to gambling."

♦ It is not permitted to purchase shares by raising interest-bearing loans through a broker or another (margin sale)

just as it is not permitted to pledge the shares for such a loan. (Standard-21 Clause 3/5)

♦ It is not permitted to sell shares that the seller does not own (short sale). (Clause 3/6)






♦ It is not permitted to lend shares of corporations. (Clause 3/9)

♦ The contract of Salam (Islamic Forward Contract) is not permitted in shares. (Clause 3/11)

♦ It is not permitted to undertake futures contracts for shares. (Clause 3/12). In futures contract, the settlement is

generally done by cash (i.e. the monetary difference is settled). As a result some scholars contend that such

contracts are primarily used for speculative purposes.

♦ It is not permitted to undertake contract of options for shares. (Clause 3/13)

♦ It is not permitted to undertake swap contracts with respect to shares and their returns.(3/14)

♦ It is not permitted to rent the shares, whether this is for pledging them or for the purpose of selling the rented

shares and returning shares similar to them. (Clause 3/15)

♦ It is not permitted to undertake trading in the shares of a corporation, when the assets of the corporation are cash

exclusively. (Clause 3/17)

♦ It is not permitted to undertake trading in the shares of a corporation if the entire assets of the corporation are

composed of debts, unless the rules for dealing in debts are observed. (Clause 3/18)

Stocks Selection & Purification Methodology

The Eligibility criteria are designed to help the Muslims to participate in the growth of equity markets and to minimize the

un-Islamic activities. The Methodology of stock selection comprises of two types of screening:

1. Industry Screen through nature of business

2. Securi ty Screen through Financial Ratio Analysis






1. Industry Screen

In the first set of filters excludes all those primary businesses involved in prohibited products:

Pork

Alcohol

Tobacco

Gambling

Entertainment

Weapon Production

Financial services ( Conventional banking, Leasing & Insurance )

2. Security Screen

Once the stocks filtered from Industry screening, they have to be analyzed through financial parameters. This screening is

also directly or indirectly related to the prohibition of Interest – based transactions, thus setting the following tolerance

levels:

Total Interest bearing debt / Total Assets: Should not be more than 1/3rd

(33.33%)

Interest – based Assets / Total Assets: Should not be more than 1/3rd

(33.33%)

illiquid Assets / Total Assets: Should not be less than 1/3rd

(33.33%)

a. Analyt ical Review of Securi ty Screen

The basis of using ‘less than 1/3rd

‘of the total assets of the company has been derived from the famous Hadith of the Holy

Prophet (Peace Be upon Him) “ One third is big or abundant” (Tirmizy). Hence whatever, is less than one third would be

insignificant.

There is an alternative approach to use market capitalization instead of total assets as a denominator. But a practica

problem of using market capitalization is that with the sudden market movement in either direction, a company which is

considered Shariah Compliant one day, it can be considered Shariah non-complaint on the next day, thus creating

confusion for investors. Other than Market Capitalization, the use of 12 or 24 months average Market Capitalization is in

practice to smooth out the volatility. But using Total Assets allows consistency in the ratio calculations by dividing an

accounting book value in the numerator by another accounting book value in the denominator.






Here is the explanation of financial ratios:

i. Total Interest bearing debt / Total Assets:It gives a measure of how much operations of the company are being financed by the Shariah non-compliant deb

component. Several contemporary Islamic indexes use different cut-off values but the most appropriate method is tha

Total interest – based Debt should not be greater than 1/3rd

of the total Assets.

( Total Debt =Short-term Debt +Long-term Debt +Current portion of Long-term Debt).

ii. Interest – based Assets / Total Assets:

According to Dr. Imran Ashraf Usmani , (written in Meezan Bank’s Guide) the company’s total short and long term

investment in non-permissible business should not exceed 30% of the company’s total market capitalization. On the

contrary, other Indexes are using Cash +Interest-bearing Investment in the numerator. I have taken all Interest – based

Assets in this Ratio with the tolerance level of 1/3rd

of the total assets.

iii. illiquid Assets / Total Assets:

The Renowned Shariah Scholar, Muhammad Taqi Usmani wrote in his book ‘An Introduction to Islamic Finance’ tha

the shares of a company are negotiable only if the company owns some illiquid assets. If all the assets are in liquid form

i.e., in the form of money, they cannot be purchased or sold except at par value. Because in this case the share

represents money only and the money cannot be traded in except at par.

Now the question arises related to the exact proportion of illiquid assets. The contemporary scholars have different views:

I. The ratio of illiquid assets must be 51% at least.

II. The illiquid assets of a company are 33%; its shares can be treated as negotiable.

III. Whenever, an asset is a combination of liquid and illiquid assets, it can be negotiable irrespective of the

proportion of its liquid, subject to two conditions; firstly, illiquid part should be in a considerable proportion and

secondly, the price of the combination should be more than the value of the liquid amount contained therein.

I have worked out as per the second view and also taken those stocks whose illiquid assets stood at 30% because at

various places 1/3rd

considered as 30% of the whole.






Purification of Earnings

a. What Shariah Standard Says?

Shariah Standard – 21 clearly states that it is compulsory to remove the prohibited income particular to the share that is

mixed up with the earnings of the corporations (Ref: Clause 3/4/6), so that the amount of non-permissible income pe

share is to be determined, at the end of the financial period, irrespective of whether the company pays dividend or not and

whether the company declares profit or loss, this amount should be donated to the charity. It is calculated as follows:

Impure income per share = Non-permissible Income

No. of outstanding shares

Thereafter, the resultant figure (Impure income per share) is multiplied by the number of shares owned by an individual

fund or institution, etc, (Ref: Clause 3/4/6/4).

It is calculated as:

Impure income per share x No. of shares owned =Resultant amount should be donated to charity.

Accordingly, elimination is not necessary for one who sells the shares before the end of the financial period (Ref: Clause

3/4/6/1).

b. The Present-day Common Practice

At present, majority of the Islamic Indexes apply the limit of non-permissible income not exceeding 5% of the total income

as arrived through the Ijma (consensus) of proficient Shariah Scholars. Subsequently, that proportional ratio must be

deducted from dividend and given to the Charity. But there is a practical problem that majority of the Islamic Indexes

calculate total income as the sum of Sales Revenue and other income (Total Income = Sales Revenue + Other

Income). In true sense, the Sales revenue is not the income because it carries the cost of sold as well. To avoid this

ambiguity, I had two options; either I would take Gross profit plus o ther income OR Profit before tax as denominator in

this ratio.

Then, I preferred to go with the method given by Shariah Standards.






c. Purif ication of Capital Gain or Not?

Mufti Muhammad Taqi Usmani wrote in his book that the Shariah scholars have different views about whether the

‘Purification’ is necessary where the profits are made through Capital gains;

Some of them observe that purification is necessary, because the market price of the share may reflect an

element of interest included in the assets of the company.

The other view negates the purification in case of share sold and capital gain earned because no specific amoun

of the price can be allocated for the interest received by the company, if it fulfills that requirement of ‘Hala

Business’, then the price of the share, in fact, is against the bulk of the assets and not against the small proportionof assets created by interest income.

Although, the second view is also valid, yet the first view is more precautious and free from doubts.

Applicat ion of Screening on Securities Listed at Karachi Stock Exchange

After Industry Screening, I took a sample of 62 stocks from numerous Sectors like Fertilizers, Cement, Textile, Oil & Gas

Power Generation, Refinery, Automobiles, Pharmaceuticals, Chemicals, Sugar, Paper & Board, Steel & Allied and

Personal Care. For Security screening, I took the financial data from their respective Audited Annual Reports and applied

related financial ratios. As a result, only 31 stocks have been sorted out, that attaining Shariah Compliance.






a. Shariah – Compliant Stocks

Stocks

Interest bearing Debt/

Total Assets %

Interest – based Assets/

Total Assets %

illiquid Assets /

Total Assets %

Impure Income

per Share (Rs.)

Abbot Pakis tan 0.00 19.55 31.12 0.89 Atl as Honda 10.22 10.78 45.60 0.31 Attock Cement 0.00 18.86 59.42 1.32BOC Pakistan L imited 0.00 14.93 48.80 1.71Colgate Palmoli ve 0.08 22.98 30.29 1.76Crescent Steel & Al lied 19.89 6.82 30.00 0.04Engro Chemical 26.80 1.52 55.39 0.01Fauji Fertilizer Company 26.55 14.29 36.30 0.97Habib-ADM Lim ited 0.00 8.00 52.59 0.05Highnoon Lab Limited 30.03 0.11 46.29 0.00Hub Power Company 17.63 1.15 42.02 0.01Husein Sugar Mills Limited 17.94 3.24 56.56 0.08ICI Pakistan Limited 0.00 1.83 50.11 0.93

Kot Addu Power Company Limited 24.46 0.14 30.86 5.51Kohinoor Energy Limited 0.00 9.56 63.05 0.22Kohinoor Sugar Mills Limited 27.46 0.09 81.90 0.00Lucky Cement Limited 27.32 0.32 79.38 0.00Nestle Pakistan Limited 32.60 0.06 56.73 0.00Nishat Mills Limited 32.08 0.18 35.54 2.11Oil & Gas Development Co. Limited 0.00 6.55 48.50 0.49Pak Elektron Li mited 30.95 0.30 50.97 0.13Pakistan Oil Field 0.00 11.49 43.69 3.29Pakistan Petroleum Ltd 0.00 20.09 41.93 3.72Pakistan Telecommunication Co 1.27 22.50 50.46 0.68Security Papers Limited 0.00 6.19 36.68 4.80Sitara Chemical Indust ries 20.50 2.93 77.55 0.49Sitara Energy L imited 24.44 0.29 67.37 0.20Sui Northern Gas Pipelines 3.15 1.40 64.03 0.74

Sui Southern Gas Company 14.74 3.01 37.89 5.66Thal Industries Corporation 30.61 0.03 57.87 0.01Unilever Pakistan Limited 28.39 0.04 38.89 0.02

(Note: Financial data has been collected from the latest Annual Reports except those companies whose financial year 2009 ended at Dec-09, as

financial reports have not been available yet.)

Description of Ratios:

¾ Interest bearing Debt / Total Assets < 33.33%

Interest bearing Debt = Short-term Debt + Long-term Debt + Current portion of Long-term Debt (From Balance Sheet)

¾ Interest – based Assets / Total Assets < 33.33%

Interest – based Assets include long & short term interest bearing investment & Deposits, Cash Balance at Bank in Deposit & Saving Accounts, investment in non-complian

industries. (From Balance Sheet)

¾ illiquid As sets / Total Assets > 30%

illiquid Assets are the fixed assets. (From Balance Sheet)

¾ Impure Income per Share = Non-permissible Income

No. of outstanding shares

Non-permissible income has been taken from the other operating income of the company that includes all types of interest income from various sources plus Gain/ Dividend

income derived from the Non-Compliant industries. (From Income Statement)






b. Shariah Non – Compliant Stocks

Attock Refinery Limited Fauji Fertilizer Bin Qasim Nishat Chunian Limited

Azgard Nine Limited Habib Sugar Mills Limited Packages Limited

Century Paper & Board Mills HinoPak Motors Limited Pak Suzuki Motor Company

Cherat Cement Ibrahim Fibres Limited Pakistan Int. Container Terminals

Clariant Pakistan Limited Indus Motor Pakistan Ltd Pakistan National Shipping Corp

Colony Sugar Mills Limited Kohat Cement Company Pakistan Refinery Limited

D.G.Khan Cement Kohinoor Textile Mills Limited Pakistan State Oil

Dawood Hercules Chemical Millat Tractors Limited Searle Pakistan Limited

Dost Steel Limited National Refinery Limited Suraj Cotton Mills Limited

Engro Polymer & Chemical NETSOL Technologies Tri Pack Films Limi ted

Fauji Cement Company

Those stocks that are found to be non-complaint either carry greater Debt/Total Assets Ratio or lower illiquid Assets /Tota

Assets Ratio. The important point to be noted here is that my intention is to remove the interest earnings from the

operations of the company to the every possible extent. Moreover, this selection & rejection of stocks from the Shariah

framework is not an everlasting assortment. It is recommended that these stocks should be reviewed regularly either on

yearly or quarterly basis as per the prescribed method. Financial reports are easily available from the companies

websites, so that one can work out to ensure that a company is not involved in any non- complaint activities.

Conclusion

Hence, the bottom-line of this article is that the Shariah Compliance is the only financially viable solution for us

that uphold the significance of research and awareness, thus min imizing the risk / uncertainty (Gharar), deriving

potential gains and maintaining the stability of the equity markets. Now it’s our own choice to adapt Shariah -

Compliant strategy sooner or later.

Disclaimer…….. All reasonable care has been taken to ensure that information contained here in is notmisleading or untrue at the time of dissemination. The author of this report is not a Shariah Scholar and notinvolved in creating new methodology. All the methodologies either are present in the Shariah Standards or inpractice by the contemporary Islamic Indices. We are not giving any guarantee for the productive returns of theselected stocks, as the returns are subjected to the market conditions. All the Information is for private use of aperson to whom it i s provided without any liability whatsoever on the part of Guardian Securities (Pvt.) Limited oemployees thereof.






Glossary Used

AAOIFI Accounting and Auditing Organization For Islamic Financial Institutions

Gharar Uncertainty, hazard, chance or risk. Technically, sale of a thing which is not present

at hand or sale of a thing whose consequences or outcome is not known.

Halal Permissible

HaramProhibited

Ijma Consensus of Shariah Scholars

Ref Reference to

Riba Increase, addition, expansion or growth, premium that must be paid without anyconsideration.

Salam Islamic Forward Sale - Advance payment for goods which are to be delivered later

Shari’ah’ The Islamic Law / way

Ummah Nation

References

♦ Shari’ah Standards……………………………………Accounting and Auditing Organization For Islamic Financial Institutions

♦ An introduction to Islamic Finance…………………..Mufti Muhammad Taqi Usmani

♦ Meezan Bank’s Guide to Islamic Banking………….Dr. Muhammad Imran Ashraf Usmani

♦ A Basic Guide to Contemporary Islamic Banking & Finance………….. Mehmoud Amin El-Gamal, Rice University, Houston

♦ Guidelines for Shariah Compliance in Islamic Banking Institutions……..State Bank of Pakistan

♦ Guide to the Dow J ones Islamic Market Indexes

♦ S&P Shariah Indices Methodology

♦ MSCI Islamic Global Indices………………………………………………….Initial Index Construction Summary – J uly 2007

♦ KSE Meezan Index……………………………………………………………..Concept Paper

Related Websites:

♦ www.learnislamicfinance.com

♦ www.islamicbanker.com

♦ www.financeinislam.com

what shariah says about equity investments

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