7 Halal Stock Screening Methodologies You Need to Know

Halal Stock Screening or Shariah-Compliant Stock Screening is the topic we will cover in this article. However, before jumping right into it, let’s have a brief look into the meaning of stock screening.

 

What is Stock Screening?

Stock screening is the process of shrinking the universe of all possible stocks down to just a few that meet the criteria of an investment strategy. It brings together strategy, data, and screeners.
Strategy is similar to a cake recipe, data to the ingredients, and screeners to the tools. Stock screening is critical because it reduces the size of the problem that we are attempting to solve. It is easier to analyze a few stocks rather than all of them.

Halal Stock Screening

Halal stock screening is used to distinguish between Shariah-compliant and non-Shariah-compliant stocks in a given market. This is critical because Islam forbids the support or continuation of Haram products or activities. In addition, the objective of Shariah-compliant stock screening is to assist investors concerned with Islamic values in locating their sweet spot in the market.
However, due to cultural and geographical differences between markets, their screening methods differ. In the following, we will discuss 7 halal stock screening methodologies that have been commonly used to evaluate the compliance of a stock.

1. AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions)

The shares of a company whose core activities are Shariah-compliant is permitted under the following conditions:

Business screening

  • The firm’s memorandum of association does not specify its goal to trade in interest or forbidden products or materials such as pork or others.
  • The total amount of revenue generated by prohibited activities should not exceed 5% of the company’s overall revenue.

Financial screening

  • The total long and short-term debt is less than 30% of market capitalization.
  • Total interest-bearing securities are less than 30% of market capitalization.
  • Impermissible income as a percentage of total income or revenue is less than 5%

2. Securities Commission (SC) Malaysia

SC Malaysia adopted a two-tier approach to the financial assessment, which applies to business activity benchmarks. Recently, SC Malaysia introduces financial ratios while maintaining quality control. Since November 2013, the new Shariah methodology has been in effect.

Business screening

There are two thresholds for business activity under the new screening methodology: 5% and 20%.

  • Companies will be included if they generate less than 5% of their revenue or profit before taxes from the following sectors; Conventional banking and insurance, gambling, non-halal food and beverages, Shariah non-compliant entertainment, interest income from conventional instruments, tobacco, and other non Shariah-compliant activities.
  • The 20% benchmark applies to companies that get a portion of their profit before taxes from the activities including hotel and resort operation, share trading and stockbroking business, rental received from Shariah non-compliant activities.

Financial screening

  • Cash as a percentage of total assets should be less than 33%.
  • The total debt to total asset ratio should be less than 33%.

The aim of both ratios is to collect and measure interest-based items on a company’s balance sheet, which should not exceed the 33% threshold.

3. DJIMI (Dow Jones Islamic Market Index)

Business screening

The income from non-compliant Shariah operations should not exceed 5% of total revenue. The Shariah non-compliant activities including alcohol, pork-related products, conventional financial services, entertainment (hotels, casino, cinema, pornography, music), tobacco, weapon, and defense.

Financial screening

  • Total debt should be less than 33% of the trailing average market capitalization.

The total debt = short-term debt + current portion of long-term debt + long-term debt.

  • Cash and interest-bearing securities should account for less than 33% of total market capitalization.
  • The ratio of accounts receivables to trailing average market capitalization should be less than 33%. Current and long-term receivables are both included in receivables.

4. MSCI (Morgan Stanley Compliance Islamic Index)

The business activities of Shariah-compliant investments should not involve or derive more than 5% of their revenue from the activities. The non-compliant activities include alcohol, pork-related products, tobacco, conventional financial services, defense/weapon, gambling/ casino, music, hotel and cinema, and adult entertainment.

Financial screening

The principles of halal investment do not allow the companies to receive more than significant income from interest or companies that have excessive debt.  

  • Total debt divided by total assets should be less than 33.33%
  • Cash and interest-bearing securities divided by total assets should be less than 33.33%
  • Accounts receivables and cash divided by total assets should be less than 33.33%

5. FTSE (Financial Times Stock Exchange Shariah Index)

Companies that receive income of more than 5% from the following activities will fall under the category of non Shariah-compliant business:

  • Conventional finance
  • Alcohol
  • Pork related products
  • Entertainment including casinos
  • Tobacco
  • Weapon and defense manufacturing

Financial screening

The companies must pass the financial ratios assessment to be considered as Shariah-compliant

  • Debt is less than 33% of total asset
  • Total company’s cash and interest-bearing securities over total asset should be less than 33.33%
  • Accounts receivables and cash are less than 50% of total assets.

6. Pakistan Meezan Islamic Fund

Meezan Islamic Fund in Pakistan has the following Shariah screening criteria for equities and other securities.

The core business of the company should be halal. Accordingly, investment in shares of conventional financial institutions like banks, insurance companies, and leasing companies are not acceptable. In addition, companies dealing in alcohol, tobacco, pornography, and so forth are not permissible.

If the company engages in business activities and earns income that is against Shariah principles, Meezan Islamic Fund’s screening methodology comprises of two conditions:

  1. The company’s total investment in Shariah–non-compliant businesses should not exceed 33% of total assets.
  2. The income from Shariah–incompatible investments should not exceed 5% of gross revenue (net sales plus other income).

Financial screening

  • Debt to Total Assets. The total interest-bearing debt of the Investee Company should not be above
    45% of the total assets.
  • Net Illiquid to Total Assets. The total illiquid assets of the company as a percentage of the total assets should be at a minimum of 10%.
  • Net Liquid Assets to Share Price. The net liquid assets (current assets minus current liabilities) per share should be less than the market price of the share.

7. Jakarta Islamic Index

The first Jakarta Islamic Index screens are intended to remove any companies with involvement in:

  • Alcohol
  • Pork-related products
  • Conventional financial services (riba/interest
  • Entertainment
  • Producing and distributing moral-damaging products
  • Tobacco
  • Weapons and defense

Financial screening

Jakarta Islamic, like other markets, uses the following three ratios to screen out companies that earn a lot of money from interest or have a lot of debt:

  1. The total debt/market capitalisation ratio must not exceed 30%.
  2. The ratio of accounts payable to market capitalization must not exceed 30%.
  3. Interest income/revenue must not exceed 5%.

It is a challenge to find a fully Shariah-compliant company. A strict operational definition of halal would result in very few Shariah-compliant stocks. Therefore, many Shariah scholars argue that if some parts of the business are involved in non-Shariah compliant activities, it does not necessarily make the entire business haram.

To read more about Islamic Finance related topics, please click here and visit our academy.

Feel free to sign up for our free stock screening services at Musaffa.com