The wonder of Shariah screening parameters
We are on asset management and I am explaining the Shariah screening parameters for listed equities. I hope the threshold of interest-bearing debt has made sense with readers. If some of you are skeptical about it, let me narrate a true story which should prove convincing enough.
In the last article, I had written on the emergence of DJIM in 1999. Do you know when the tech bubble (or dot-com bubble) burst in New York? It was in 2001, ie exactly two years after the launch of DJIM.
The tech bubble emerged during the period of 1995 to 2001 when the value of companies dealing with internet skyrocketed. This was the time of people realizing how important internet could be to their daily life. Mind you, this was also despite there being no Youtube, Twitter, Facebook, WhatsApp, LinkedIn or any other social media platform. Looking at it from today’s perspective, it was a blind and bland world.
Another factor for the rise of tech stocks during the aforementioned period was that the interest rates were low in the US, which led to gambling on technological stocks by relying on bank borrowings. Like any other artificial run, this too could not sustain itself and what was expected happened. The tech bubble burst and it did so in a bad manner, sinking a large number of funds, banks and individual investors.
In all of this mayhem, one group of investors kept their cool and retained their smile. Yes, it may sound bizarre but the followers of Islamic indices and investors in Islamic funds globally breathed a sigh of relief upon knowing that they have come out unscathed from the disastrous collapse of various conglomerates in the US during the burst.
The miraculous escape was made possible by the application of Shariah screening parameters on these companies by the Islamic index managers under the supervision of Shariah scholars. As the companies failed to clear the interest-bearing debt parameter, the Islamic indices exited them well ahead of their eventual collapse.
One of the failed companies was WorldCom, the giant US telecom darling, which was worth US$185 billion in 2000 — larger than the total economies of Saudi Arabia and the UAE combined at the time.
Naturally, any investor would feel proud to be part-owner of this ultra-giant organization. As such, the decision by the Islamic index provider to exit the company from the Islamic indices at its peak had surprised many investors, who were unhappy and unconvinced about the decision.
When the WorldCom empire came crumbling down like a house of cards in 2002 due to a combination of factors but mainly due to excessive debt, outright fraud and bad accounting practices, the shockwaves were felt in all corners of the world. Billions of dollars were wiped out overnight and the glossy share certificates became worthless.
None could see it coming except a group of investors who religiously followed DJIM. The index had removed WorldCom in June 2001 (ie about six months before the collapse) because its debt-to-market capitalization ratio had breached the Shariah barrier of 30%.
Islamic fund managers around the world were unwillingly compelled to liquidate their portfolio on the WorldCom, which eventually saved them from losing hundreds of millions of dollars. At the time, the WorldCom share was quoted at US$14 compared with a penny later on.
Similar to WorldCom, the other conglomerates removed were Tyco and Enron. In each case, the decision to exit was taken well ahead of the collapse, thereby saving the Islamic investors from substantial losses. Gradually, the far-sightedness of the parameters adopted by the Islamic index managers was globally recognized and it is now widely believed that Shariah screening is capable of identifying the early signs of trouble in a publicly listed and traded company.
For investors worldwide, it is a welcome change from the days when they had no choice but to believe the rosy picture painted by the companies. Now they can not only follow the Islamic indices and liquidate their investment in a company upon its removal from the indices but also undertake such screening on their own upon the availability of financial data. In fact, a large number of investors and conventional fund managers keep a vigil on equities being added or taken out from the Islamic indices and make a decision.
However, this newfound ‘safety framework’ is limited to the equities of the companies having their activities within the Shariah ambit. Companies with operations repugnant to Shariah principles fail to even cross the first hurdle and as such are not included in the Islamic indices despite complying with all other ratios.
You may find it unusual but the multinational public joint stock companies around the world with activities acceptable under Shariah principles are getting increasingly concerned with Shariah screening parameters, especially their debt levels. As such, the sudden recognition of the genius of Islamic indices by investors internationally had created a quasi-regulatory environment way before stricter controls were introduced in the wake of the financial crisis of 2008.
I would like to end today by drawing your attention to my statement in the last article that by far, most publicly listed companies are unable to qualify for Islamic indices mainly due to not being able to meet the debt screening parameter.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at sazubairi1979@gmail.com.
Next week: Discussion on Shariah screening parameters to continue.
