The technology sector has done fairly well when it comes to Shariah compliancy of stocks listed on exchanges around the world.
On Thursday, November 7, 2013, Twitter went public with a well-publicised IPO, sparking interest from investors around the world. Before this, Facebook went for a rather controversial IPO on May 18, 2012.
Edbiz Consulting, a London-based Islamic finance advisory firm that has partnered with Nasdaq to develop a Shariah-compliant version of Nasdaq100, reported that Twitter stock was Shariah compliant when the company went public. What does it mean?
There are a number of Shariah screening methodologies that have been employed by index providers around the world to construct, maintain and market what are known as Islamic indices. The most widely used methodology is that of Dow Jones but other methodologies, ie, that of FTSE, MSCI and Nasdaq do not significantly differ.
There are two screens employed by Shariah screening companies – business screen and financial screen. The former ensures that the overall business of a firm is not outright in contradiction with Islamic teachings on business and commerce. The business screen, therefore, excludes all the stocks that lie in the impermissible sectors like financials (except Islamic banks and other financial institutions that explicitly commit to Shariah guidelines for conducting their businesses), gambling and gaming, entertainment (including but not limited to pornography), weapons manufacturing, alcohol, pork, tobacco, etc.
The financial screen is based on a number of financial ratios. The most frequently used financial ratios are the following:
*Gearing ratio – total interest-bearing debt divided by market capitalisation of the company
*Liquidity ratio – cash plus interest bearing securities divided by market capitalisation
*Cash flow ratio – receivables divided by market capitalisation
*Income ratio – impermissible income divided by total income
Dow Jones Shariah screening methodology employs the above-mentioned gearing ratio, liquidity ratio and cash flow ratio and excludes all those stocks that exceed a threshold level of 33%. They recommend to investors to employ a 5% threshold for the income ratio, although they do not incorporate income ratio in the process of constructing and maintaining their family of Islamic indices.
FTSE, on the other hand, uses total assets in the denominator as opposed to market capitalisation when computing the above ratios. They also include cash in addition to the receivables in the numerator when calculating the cash flow ratio. They use 33.33% as threshold for the gearing and liquidity ratios while a higher threshold level (50%) for the cash flow ratio.
FTSE may seem a bit liberal financial screening methodology but it actually depends on market conditions to infer whether it is more conservative or liberal as compared to Dow Jones. In bullish market conditions, Dow Jones may prove to be more liberal than FTSE, and the other way around in bearish markets.
MSCI has a similar approach to FTSE in terms of denomination of ratios but its thresholds are more consistent with Dow Jones. All the three ratios have a threshold of 33.33%.
Russell-Jadwa Islamic indices use financial ratios similar to Dow Jones’s but threshold of their cash flow ratio (with cash included in the numerator) is far higher than the Dow Jones’s – 70% for Russell-Jadwa as opposed to 33% for Dow Jones.
Securities Commission of Malaysia uses a more detailed Shariah screening methodology. Unlike other methodologies (which use 5% threshold for the income ratio), SC uses two thresholds for this ratio to determine whether a business is Shariah compliant.
Stocks are excluded from Shariah universe if the business of the companies issuing such stocks generates more than 5% of revenue from the following sectors:
Conventional banking including insurance; gambling; liquor and liquor-related activities, pork and pork-related activities, non-Halal food and beverages; Shariah repugnant entertainment; interest income from conventional accounts and instruments; and tobacco and tobacco-related activities and other activities deemed Shariah repugnant.
The stocks will be excluded from Shariah universe only if the issuing companies generate more than 20% of their income from the following business activities:
Hotel and resort operations, share trading and stock broking business, rent received from tenants engaged in Shariah repugnant businesses; and other activities that are deemed Shariah repugnant.
Other financial ratios (ie, gearing ratio and liquidity ratio) are the same as that of FTSE.
In the context of Pakistan, Meezan Bank’s Shariah screening methodology is adopted by a number of Islamic equity fund managers. It is perhaps the most detailed approach to Shariah screening. Business screen is consistent with other international Shariah screening methodologies. However, it employs following five financial ratios with the stated thresholds:
*Gearing ratio, as defined by total interest-bearing debt divided by total assets, should be less than 37%
*Investment ratio, as defined by Shariah repugnant investments divided by total assets, should be less than 33%
*Income ratio, as defined by impermissible income divided by total revenue, should be less than 5%
*Illiquidity ratio, as defined by illiquid assets divided by total assets, should not be less than 25%
*Market price per share should be at least equal to or greater than net liquid assets per share
Twitter stock met the requirements of all the internationally known Shariah screening methodologies. This is true for Facebook stock as well, which along with Google, is included in Nasdaq100 Shariah index.
Another interesting stock is Apple, which was Shariah compliant until its iTunes businesses started generating more revenue, making it non-compliant as it breached the 5% threshold on the income ratio.
The writer is an economist and a PhD from Cambridge University
Published in The Express Tribune, November 18th, 2013.
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