The goals of the Shariah screening process
We now know that the Shariah screening process enables an Islamic index manager to decide whether a particular stock should either be added to the Islamic index, or if added, whether it should continue to stay there.
Let us examine as to what the purpose of such screening is and what an Islamic index manager wants to achieve from this cumbersome process for the benefit of a set of cautious investors.
The broad purpose of the overall screening is to be able to know whether or not a publicly listed company’s business practices are overleveraged, manipulative, unethical or inefficient in dealing with banks, suppliers, customers, creditors and debtors.
The purpose of the first screening relating to the total interest bearing debt remaining below one-third of a company’s average market capitalization during last 12 months is to discourage the company from amassing interest-bearing debt beyond a manageable level.
We have seen time and again that such a practice by a company leads to the point where it becomes difficult, if not impossible, to manage servicing the debt. In fact, new debt is taken to repay the existing one.
Of course, in a western or non-Islamic economic environment, it will be naïve to expect that a company will not have interest-based borrowings. However, scholars strongly believe that a red line must be drawn beyond which the interest-based borrowings start to jeopardize investors’ interest. Hence, one-third is that red line.
How effective has this Shariah screening parameter been in protecting Islamic investors? I have already explained it in recent articles through the examples of WorldCom, Tyco and Enron. Add to that the French conglomerate Parmalat which collapsed for the same reason in 2003.
The aim of the covenant relating to interest income and earnings from non-Shariah compliant means put together not exceeding 5% of a company’s total income is to encourage the company to invest its surplus funds in trading to earn operating profit, instead of complacent interest income where the company does not make any effort at all to earn it.
The parameter concerning interest-bearing placements and securities (interest-based lending) not crossing one-third of a company’s 12-month market capitalization also serves the same purpose as described above. The aim is for the company to expand organically to be able to generate true income from operation, instead of artificial income through interest and such other means.
The filter concerning the cash and receivables combined not crossing over one-third of the 12-month average market capitalization clearly addresses the quality of a company’s debtors. You may recall the very early articles in this series where I had written about non-permissibility of making money out of money and trading in debt. As such, if a company’s cash and debt combined breaches the boundary, the index manager cannot help but exclude it from the Islamic index.
On the other hand, by deploying an efficient debt recovery means, a company will be able to rely less on borrowed funds and hence will incur lower interest expense, thereby improving its overall income as well as the Shariah acceptability by the Islamic index’s Shariah board.
A question which comes to mind is who monitors these parameters? Well, these well-thought measures are religiously monitored on an ongoing basis by index managers around the world.
A company is removed from an index if it fails to meet any of the above litmus tests. The integrity of an Islamic index is gauged by the frequency of periodic reviews conducted by its Shariah board.
Are the companies in an Islamic index wary of such screening?
Initially, it was not at all considered to be an issue by the blue-chip companies which carried large weight in an Islamic index.
However, as activity in the Islamic market picked up considerably over the years and due to the emergence of more Islamic indices and funds almost covering the entire globe, there is growing awareness among these companies as to the importance of Islamic investors who are guided by the Islamic indices.
On the other hand, after the collapse of a number of large international blue-chip players due to unbearable debt, there has been stricter debt regulations which are proving helpful in making these companies eligible to enter or remain in an Islamic index.
Are there liquidity criteria for selection of stocks?
Though not a Shariah requirement, the promoters of Islamic indices and funds have so far tried to play it safe by selecting actively traded stocks from the developed world. Their purpose seems to be to have easy access and exit in order to provide greater flexibility to an Islamic investor in this relatively new investment field.
The stock screening is carried out through the screening engine to get a fast result. It is not possible to do so manually for thousands of listed shares in different jurisdictions. Also, the latest financial data is critical to give a true picture whereas stale data carries a high risk of misjudging a stock.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Next week: Discussion on Shariah screening parameters to continue.