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What Shariah Says About Equity Investment?

Saba Akhlaque Khan


Director Investments
Saba.khan@guardiansecurities.com.pk

February 04, 2010

G GU UA AR RD DI IA AN N R RE ES SE EA AR RC CH H

Shariah Compliant Equity Investment

In the name of Allah, the most merciful and beneficent

The Holy Quran Says:

And fear the Day when you shall be returned to the Lord and every soul shall be paid in full what it has earned and no one shall be wronged.

(Surah al-Baqarah, Verse: 281)

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Shariah Compliant Equity Investment

Table of Contents Contents


The Perception of Equity Investment Prohibited Transactions in Shariah Stocks Selection & Purification Methodology 1. Industry Screen 2. Security Screen a. Analytical Review of Security Screen 1. Total Interest bearing debt / Total Assets 2. Interest based Assets / Total Assets 3. illiquid Assets / Total Assets Purification of Earnings a. What Shariah Standards Say b. The Present-day Common Practice c. Purification of Capital Gain or Not? Application of Screening on Securities Listed at Karachi Stock Exchange a. Shariah Compliant Stocks b. Shariah Non Compliant Stocks Conclusion Glossary Used References

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Shariah Compliant Equity Investment

The Perception of Equity Investment We


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

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 todays 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). Thats 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 that 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)

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Shariah Compliant Equity Investment

The prime purpose for writing this research paper is to evoke the awareness about the Shariah norms of investment to all 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 selection and 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 & Poors Shariah Indices Screening Criteria of SEC, Malaysia Screening Criteria of Dubai Islamic Bank Screening Norms of National Commercial Bank, Saudi Arabia

Prohibited 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 prohibited Bay
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)

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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. Security Screen

through Financial Ratio Analysis

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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: Interest based Assets / Total Assets: illiquid Assets / Total Assets: Should not be more than 1/3rd (33.33%) Should not be more than 1/3rd (33.33%) Should not be less than 1/3rd (33.33%)

a. Analytical Review of Security 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 practical 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.

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Here is the explanation of financial ratios:

Shariah Compliant Equity Investment

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 debt component. Several contemporary Islamic indexes use different cut-off values but the most appropriate method is that 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 Banks Guide) the companys total short and long term investment in non-permissible business should not exceed 30% of the companys 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 that 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.

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Shariah Compliant Equity Investment

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 per 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 other income OR Profit before tax as denominator in this ratio.

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

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Shariah Compliant Equity Investment

c. Purification 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 amount of the price can be allocated for the interest received by the company, if it fulfills that requirement of Halal Business, then the price of the share, in fact, is against the bulk of the assets and not against the small proportion of assets created by interest income.

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

Application 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.

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Shariah Compliant Equity Investment

a. Shariah Compliant Stocks


Interest bearing Debt/ Stocks
Abbot Pakistan Atlas Honda Attock Cement BOC Pakistan Limited Colgate Palmolive Crescent Steel & Allied Engro Chemical Fauji Fertilizer Company Habib-ADM Limited Highnoon Lab Limited Hub Power Company Husein Sugar Mills Limited ICI Pakistan Limited Kot Addu Power Company Limited Kohinoor Energy Limited Kohinoor Sugar Mills Limited Lucky Cement Limited Nestle Pakistan Limited Nishat Mills Limited Oil & Gas Development Co. Limited Pak Elektron Limited Pakistan Oil Field Pakistan Petroleum Ltd Pakistan Telecommunication Co Security Papers Limited Sitara Chemical Industries Sitara Energy Limited Sui Northern Gas Pipelines Sui Southern Gas Company Thal Industries Corporation Unilever Pakistan Limited

Interest based Assets/ Total Assets % 19.55 10.78 18.86 14.93 22.98 6.82 1.52 14.29 8.00 0.11 1.15 3.24 1.83 0.14 9.56 0.09 0.32 0.06 0.18 6.55 0.30 11.49 20.09 22.50 6.19 2.93 0.29 1.40 3.01 0.03 0.04

illiquid Assets / Total Assets % 31.12 45.60 59.42 48.80 30.29 30.00 55.39 36.30 52.59 46.29 42.02 56.56 50.11 30.86 63.05 81.90 79.38 56.73 35.54 48.50 50.97 43.69 41.93 50.46 36.68 77.55 67.37 64.03 37.89 57.87 38.89

Impure Income per Share (Rs.) 0.89 0.31 1.32 1.71 1.76 0.04 0.01 0.97 0.05 0.00 0.01 0.08 0.93 5.51 0.22 0.00 0.00 0.00 2.11 0.49 0.13 3.29 3.72 0.68 4.80 0.49 0.20 0.74 5.66 0.01 0.02

Total Assets % 0.00 10.22 0.00 0.00 0.08 19.89 26.80 26.55 0.00 30.03 17.63 17.94 0.00 24.46 0.00 27.46 27.32 32.60 32.08 0.00 30.95 0.00 0.00 1.27 0.00 20.50 24.44 3.15 14.74 30.61 28.39

(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: 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) 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-compliant industries. (From Balance Sheet) illiquid Assets / Total Assets > 30% illiquid Assets are the fixed assets. (From Balance Sheet) 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)

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Shariah Compliant Equity Investment

b. Shariah Non Compliant Stocks


Attock Refinery Limited Azgard Nine Limited Century Paper & Board Mills Cherat Cement Clariant Pakistan Limited Colony Sugar Mills Limited D.G.Khan Cement Dawood Hercules Chemical Dost Steel Limited Engro Polymer & Chemical Fauji Cement Company Fauji Fertilizer Bin Qasim Habib Sugar Mills Limited HinoPak Motors Limited Ibrahim Fibres Limited Indus Motor Pakistan Ltd Kohat Cement Company Kohinoor Textile Mills Limited Millat Tractors Limited National Refinery Limited NETSOL Technologies Nishat Chunian Limited Packages Limited Pak Suzuki Motor Company

Pakistan Int. Container Terminals Pakistan National Shipping Corp


Pakistan Refinery Limited Pakistan State Oil Searle Pakistan Limited Suraj Cotton Mills Limited Tri Pack Films Limited

Those stocks that are found to be non-complaint either carry greater Debt/Total Assets Ratio or lower illiquid Assets /Total 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 minimizing the risk / uncertainty (Gharar), deriving potential gains and maintaining the stability of the equity markets. Now its 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 not misleading or untrue at the time of dissemination. The author of this report is not a Shariah Scholar and not involved in creating new methodology. All the methodologies either are present in the Shariah Standards or in practice by the contemporary Islamic Indices. We are not giving any guarantee for the productive returns of the selected stocks, as the returns are subjected to the market conditions. All the Information is for private use of a person to whom it is provided without any liability whatsoever on the part of Guardian Securities (Pvt.) Limited or employees thereof.

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Shariah Compliant Equity Investment

Glossary Used
AAOIFI Gharar Accounting and Auditing Organization For Islamic Financial Institutions 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 Haram Ijma Ref Riba Salam Shariah Ummah Permissible Prohibited Consensus of Shariah Scholars Reference to Increase, addition, expansion or growth, premium that must be paid without any consideration. Islamic Forward Sale - Advance payment for goods which are to be delivered later The Islamic Law / way Nation

References
Shariah StandardsAccounting and Auditing Organization For Islamic Financial Institutions An introduction to Islamic Finance..Mufti Muhammad Taqi Usmani Meezan Banks 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 Jones Islamic Market Indexes S&P Shariah Indices Methodology MSCI Islamic Global Indices.Initial Index Construction Summary July 2007 KSE Meezan Index..Concept Paper

Related Websites:

www.learnislamicfinance.com www.islamicbanker.com www.financeinislam.com

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