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Stock Screening Process

Stock Screening Process

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Published by: syed othman alhabshi on Oct 04, 2008
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STOCK SCREENING PROCESS By Prof. Datuk Dr. Syed Othman Alhabshi INCEIF 1.

DEFINITION Stock screening is a process of determining whether a stock or security is Shariahcompliant or not. It consists of various Shariah principles that form the criteria which should be used to determine whether the stock or security is Shariah-compliant or not. 2. OBJECTIVE The main objective of screening the stock is to ensure that the stock or security that one purchases or invest in does not contain any prohibited elements that make it Shariah non-compliant. For Muslims, it is a grave sin to consume something that is unlawful or prohibited. According to a hadith of the Holy Prophet (peace and blessings of Allah be upon him) as reported by Jabir (may Allah be pleased with him), the Messenger of Allah said: “The flesh grown from unlawful provisions shall not enter Paradise, and every flesh grown from unlawful provisions deserves to be thrown in the Hell fire” (Ahmad). From the hadith, it is clear that Muslims need to be very careful not to consume or feed his family with food that originates from unlawful income. In fact it is not just food that we consume must be permissible, it is all that we consume in the general sense should be pure and clean. 3. SCOPE OF THIS PAPER This paper will confine discussion only on the stock screening processes as adopted by the Securities Commission of Malaysia (SC) and the Dow Jones Islamic Market Index (DJIM). 4. SHARIAH PRINCIPLES IN ISLAMIC TRANSACTIONS To ensure that we consume only what is permitted, we have to ensure that the income that we earn and the resulting wealth that we generate and accumulate must have been done through lawful means. To help us ensure this, the Shariah has laid down the basic principles that should be followed in our business or commercial transactions. The Holy Qur’an also states, “O ye who believe! Eat not up your property among yourselves in vanities; but let there be amongst you traffic and trade by mutual goodwill: Nor kill (or destroy) yourselves: for verily God hat been to you Most Merciful” [An-Nisaa (4):29]

From the above verse, it is clear that we should not take each others wealth or property through vain means. But there should be proper, transparent, fair and just exchange or transactions which are mutually agreed by both parties. At the end of the verse, it says about killing or destroying oneself which implies that by cheating or forcing one to give up his property you are in fact killing his livelihood although he may not die. Based on such interpretations of the verse, the scholars have outlined the principles of Islamic transactions as follows: • • • • • Willing buyer Willing seller Well defined or specified good, commodity or product Agreed price Offer and acceptance

The following can be derived from the above list of requirements: First, the participants in transactions must be of age, free man, represented if blind and sane individual. Underage person is not allowed to transact unless permitted by the guardian or parents. Second, the good or commodity or product must be well defined or specified to avoid any ambiguity or uncertainty (gharar) which is prohibited. The good must be owned by the seller and can be delivered at the appointed time. Third, both parties need to agree on the price Fourth, the offer and acceptance can be verbal or in writing which acts as the conclusion of the agreement by both parties to the transaction. The Holy Qur’an has addressed mankind thus: “O ye people! Eat of what is on earth, lawful and good and not follow the footsteps of the evil one, for he is to you an avowed enemy” [Al-Baqarah (2): 168]. The verse clearly states two basic criteria in selecting food for our consumption, namely, they should first be lawful and secondly they should be good. From the science of the Holy Qur’an, the order of the words in the verse implies that we should choose food that is lawful first. Among the lawful food we should then choose those that are good for us. There are two implications here: First, it implies that what is lawful must be good. However, what is good may not be lawful such as strong drinks. Secondly, what is good for someone may not be good for another. Hence, one should be selective in choosing among the lawful what is good for him. While the first verse outlines the basic principles of Islamic transactions in general, the second provides the basis for stock screening. This does not mean that the basic principles of Islamic transactions do not apply in the stock screening process. In fact, the third principle of Islamic transactions which pertains to good or product to be 2

transacted is further clarified by the second verse quoted above. In other words the stock cannot contain any prohibited elements whether by action or by contents. Stock screening therefore entails the scrutiny of the good or product of the company and the manner it is being produced, particularly in terms of financing. 5. UNIVERSE CREATION AND STOCK SELECTION1 The universe for Securities Commission (SC) of Malaysia is limited only to those stocks or securities that are listed in Bursa Malaysia. This includes those securities listed in the First and Second Boards as well as in Masdeq. The universe for Dow Jones Islamic Market Index (DJIM) is based on global markets. The DJMI include stocks from 34 countries and cover 10 economic sectors, 18 market sectors, 40 industry groups and 70 subgroups. Currently, the Dow Jones Islamic Market family of indices consists of the broad DJ Islamic Market Index, the DJ Islamic Market Canadian Index, the DJ Islamic Market UK Index, the DJ Islamic Market Europe Index, and the DJ Islamic Market Asia/Pacific Index. Both the Securities Commission (SC) of Malaysia and Dow Jones Islamic Market Index (DJIM) have the same approach to the first level of screening which is based on core business. The core business is considered permissible as long as they do not belong to any of those businesses that are listed as non-permissible. The SC listed the non-permissible core businesses as follows: • • • • • • • • Financial services based on riba (interest); Gambling and gaming; Manufacture or sale of non-halal products or related products; Conventional insurance; Entertainment activities that are non-permissible according to Shariah; Manufacture or sale of tobacco-based products or related products; Stock broking or share trading in Shariah-non compliant securities; and Other activities deemed non-permissible according to Shariah

For DJIM most Shariah boards have advised against investment in companies involved in the following activities: • • • •
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Alcohol Tobacco Pork-related products Conventional financial services (banking, insurance, etc.)

This section onwards has made reference to Securities Commission booklet on “List of ShariahCompliant Securities by the Shariah Advisory Council of the Securities Commission” dated 25 May 2007 and the Dow Jones Islamic Market Index website

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• •

Weapons and defense Entertainment (hotels, casinos/gambling, cinema, pornography, music, etc.)

Shariah-compliant securities include ordinary shares, warrants and transferable subscription rights (TSRs). This means that warrants and TSRs are classified as Shariah-compliant securities provided the underlying shares are also Shariahcompliant. On the other hand, loan stocks and bonds are Shariah non-compliant securities unless they are issued based on Shariah principles 6. SCREENING FROM SOURCES OF INCOME (A)By the Securities Commission of Malaysia Having got the universe of securities with permissible core business, the Shariah Advisory Committee (SAC) of SC also scrutinizes the level of contribution of interest income received by the company from conventional fixed deposits or other interest bearing financial instruments. In addition, dividends received from investment in Shariah-non compliant securities are also considered in the analysis carried out by the SAC For companies with activities comprising both permissible and non-permissible elements the SAC considers two additional criteria: • • the public perception or image of the company must be good; and the core activities of the company are important and considered maslahah (benefit in general) to the Muslim ummah (nation) and the country and the non-permissible element is very small and involves matters such as umum balwa (common plight and difficult to avoid) ‘uruf (custom) and the rights of the non-Muslim community which are accepted by Islam

(B) By the Dow Jones Islamic Market Index (DJMI) During the component selection process, each company in the index universe is examined based on its revenue allocation. If the company has business activities in any one of the following sectors defined by the Industry Classification Benchmark (ICB), it is considered inappropriate for Islamic investment purposes and is excluded from the index. Defense Distillers & Vintners Food Products Recreational Products Tobacco Food Retailers & Wholesalers Broadcasting & Entertainment Media Agencies Banks Full Line Insurance Insurance Brokers Property and Casualty Insurance Reinsurance Life Insurance Real Estate Holding & Development Consumer Finance 4

Gambling Hotels Recreational Services Restaurants and Bars

Specialty Finance Investment Services Mortgage Finance

7. TOLERABLE LEVEL OF NON-PERMISSIBLE ELEMENTS (A)By the Securities Commission of Malaysia To determine the tolerable level of mixed contributions from permissible and nonpermissible activities towards turnover and profit before tax of a company, the SAC has established several benchmarks based on ijtihad (reasoning from the source of Shariah by qualified Shariah scholars). If the contributions from non-permissible activities exceed the benchmark, the securities of the company will be classified as Shariah-non compliant. The benchmarks are: The five-percent benchmark It is used to assess the level of mixed contributions from the activities that are clearly prohibited such as riba, (interest-based companies like conventional banks), gambling, liquor and pork The 10-percent benchmark It is used to assess the level of mixed contributions from the activities that involve the element of umum balwa which is a prohibited element affecting most people and difficult to avoid. An example of such a contribution is the interest income from fixed deposits in conventional banks. This benchmark is also used for tobacco-related activities The 20-percent benchmark It is used to assess the level of contribution of mixed rental payment from Shariah non-compliant activities, such as rental payments from premises used in gambling, sale of liquor, etc. The 25-percent benchmark It is used to assess the level of mixed contributions from the activities that are generally permissible according to Shariah and have an element of maslahah to the public, but there are other elements that may affect the Shariah status of these activities. Among the activities that belong to this benchmark are hotel and resort operations, share trading, stock broking and others as these activities may also involve other activities that are deemed non-permissible according to the Shariah.

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(B) By the Dow Jones Islamic Market Index (DJMI) For DJIM, after removing companies with unacceptable primary business activities, the remaining stocks are evaluated according to several financial ratio filters. The filters are based on criteria set by the Shariah supervisory Board to remove companies with unacceptable levels of debts or impure interest income. All of the following must be less than 33%: • Total debt divided by trailing 12-month average market capitalization • The sum of a company’s cash and interest-bearing securities divided by trailing 12-month average market capitalization • Accounts receivables divided by 12-month average market capitalization 8. CHANGE OF SHARIAH-COMPLIANT STATUS As a guide to investors, the SAC would like to advise investors on the timing for the disposal of securities which have been classified as Shariah non-compliant. “Shariah-Compliant Securities Which Are Subsequently Considered “Shariah Non-Compliant” This refers to those securities which were earlier classified as Shariah-compliant securities but due to certain reasons, such as changes in the companies’ operations, are subsequently considered Shariah non-compliant. In this regard, if on the date the updated list takes effect (e.g. 25 May 2007), the value of the securities held exceeds the original investment cost; investors who hold such Shariah non-compliant securities must liquidate them. Any capital gain arising from the disposal of the Shariah non-compliant securities made at the time of the announcement can be kept by the investors. However, any excess capital gain derived from the disposal after the announcement day at a market price that is higher than the closing price on the announcement day should be channeled to charitable bodies. On the other hand, investors are allowed to hold their investment in the Shariah noncompliant securities if the market price of the said securities is below the original investment cost. It is also permissible for the investors to keep the dividends received during the holding period until such time when the total amount of devidends received and the market value of the Shariah non-compliant securities held equal the original investment cost. At this stage, they are advised to dispose of their holding. In addition during the holding period, investors are allowed to subscribe to: • any issue of new securities by the company whose Shariah non-compliant securities are held by the investors, for example rights issues, bonus issues, special issues and warrants [excluding securities whose nature is Shariah noncompliant, e.g. irredeemable convertible unsecured loan stock (ICULS)]; and 6

securities of other companies offered by the company whose Shariah-non compliant securities are held by the investors

on condition that they expedite the disposal of the Shariah non-compliant securities. For securities of other companies [as stated in (b) above], thy must be Shariahcompliant securities. Shariah Non-Compliant Securities The SAC advises investors who invest based on Shariah principles to dispose of any Shariah non-compliant securities which they presently hold, within a month of knowing the status of the securities. Any gain made in the form of capital gain or dividend received during or after the disposal of the securities has to be channeled to charitable bodies. The investor has a right to retain only the original investment cost. Note: Original investment cost may include brokerage cost or other related transaction cost.

9. PURIFICATION OR CLEANSING PROCESS Purification or cleansing is normally done when we know for sure that part of the income or revenue of the company that is Shariah compliant • • • derives from non-permissible sources such as interest on conventional fixed deposits; or contributed by a portion of capital that is obtained through conventional loan; or some other sources that are Shariah non-compliant

Such income as described above could be cleansed from the total revenue or profits by channeling it to charitable organizations. This act is called cleansing. However both the SC and DJIM do not practice cleansing. It is only when the status of the securities have changed to Shariah-non compliant that cleansing is done, provided the disposal is done after the date of announcement that the securities have changed status to Shariah non-compliant. 10. PERIODIC AND ONGOING REVIEW The composition of Shariah-compliant securities is reviewed periodically on a quarterly and annual basis. Ongoing review is also conducted especially to accommodate extraordinary events such as delisting, bankruptcy, merger, takeover etc. which may affect the status of the security. 11. CONCLUSION

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Despite general acceptance of the screening processes adopted by various markets globally there are still doubts in the minds of some who feel that there should not be any compromise in screening. The security has to be either Shariah-compliant or otherwise. The situation as it presents clearly admits non-permissible elements. How come? What Shariah principle is involved? Whether we look at the approach of the SC or the DJMI we find that there is something in common. Both comply to the principle of non-wastage such as the way the Shariah treats water when some amount of filth falls into it. As long as there is no change in colour, taste or appearance, the water is still considered clean and pure. God knows best

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