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Published in the 1-15 July 2005 print edition of MG; send me the print edition

Investing in stock market: the Shariah way

By

The Milli Gazette Online

Islamic economists and financial experts agree that if certain conditions are met, it is lawful to invest in the stock market. Any earnings that result from such investments will be halal. The logic behind this argument is that when one purchases shares in a company he actually becomes a shareholder and thus becomes a partner in the business. Thus, this arrangement is akin to the Islamic concept of musharakah. However, there are a host of conditions that must be satisfied before one is allowed to invest in stocks. To start with, one must be sure that the business of the corporation/company offering the stock must be halal. Over and above this, shariah scholars have developed certain financial parameters for stocks selection. These are mainly related to the capital structure of the company. The purpose of these criteria is to determine the level of involvement of riba (interest) and gharar (uncertainty) in the overall business of the company.

One should keep in mind that these criteria are the results of modern fiqh scholarship (ijtihad) and therefore, should be seen to represent the current state of thinking on the issue. In that way, they represent the maximum tolerance levels and not the last word on the subject. In short, if a Muslim investor is contemplating investment in the stock market, he must not only be careful about the profitability but also about the compliance of shariah. These can be done by looking at the nature of business, percentage of income from interest and the financial soundness of the company. While there are a number of tools available to help understand the financial soundness of a company there are not many that can guide an investor in determining the shariah compliance of a stock. Following screening patterns may be helpful in determining the shariah compliance of stocks.

Islamic Investment Criteria

A. Qualitative Screens
There are two types of qualitative screens:
i. Industry screening: Is the company in a business that is prohibited or abhorred in Islam? Apart from investment in banking and finance there are a number of business activities that are considered to be prohibited in Islam, and thus investing in these kinds of businesses is not something a Muslim would like to undertake such as alcoholic beverages, pork and pork products, tobacco products, gambling, lottery, pornography and adult oriented material, prostitution and drugs etc.
ii. Business practices: Following shariah principles are applicable to investing and trading practices applicable to individual investors as well as Islamic financial institutions:

a. Investible funds must be free of interest based debt:
The investor cannot borrow on interest to finance his investments, and therefore cannot trade on margin i.e., borrow to purchase shares. Conventional hedge funds, arbitrage funds, and leveraged buy-out (LBO) funds are prohibited for Islamic investors as they all borrow heavily in order to finance their investment practices.

b. Prohibition of speculation
Unlike conventional investors Muslims cannot base their investment decisions on short-term speculation. They cannot enter the market as speculators but only as investors.

B. Quantitative Screens

There are three types of quantitative screens:
i. Debt/Asset Ratio:
Has the company borrowed funds on interest? Ideally there should be no interest-based debt, but based on the Islamic legal principle "li al-akthar hukm al-kul" (to the majority goes the verdict of the whole) and subsequent scholarly opinions, a company is not a permissible investment if debt financing is more than 33% of its capital. This could be calculated as Total Debt divided by Trailing 12-Month Average Market Capitalization (where Total Debt = Short-Term Debt + Current Portion of Long-Term Debt + Long-Term Debt).

ii.Interest-related Income
Does the company generate any interest or interest-related income? This only includes those companies which do not make earning interest their business, but place their surplus funds in investments that yield interest income. As in the previous case, ideally no income should come from interest-related sources. However, looking at the current situation shariah scholars have permitted to invest in stocks of companies whose income from interest forms less than 5% of a company's total income. Some scholars have fixed that ceiling at 10% of a company’s total income.

iii. Monetary Assets
To invest in shariah compliant companies, one has to be very careful about company's monetary assets. Accounts receivables and liquid assets such as bank accounts and marketable securities have to be below the limits fixed by shariah scholars for the investment to be permissible. Some scholars have set this minimum at 51% whereas the majority of shariah scholars agree that "Accounts Receivables" should not be over 45% of company's total assets (where Accounts Receivables = Current Receivables + Long-Term Receivables).

C. Trading Practices

i. Day Trading
Day trading has little to do with actual investing. Usually day traders watch the market and buy and sell on short-term price fluctuation (normally within one day). For this reason, a number of Islamic scholars have termed this as closer to gambling and thus it is prohibited.

ii. Margin Trading:
Margin trading is buying stocks using money loaned from the broker. Interest is paid for this loan, and therefore it is prohibited. Moreover this is a very risky (and complicated) practice, as one can lose more than what he has borrowed.

iii. Derivatives - Options and Futures
Option is purchasing the right to buy or sell a stock or a commodity at a future date for a fixed price (regardless of the then prevailing price in the market). Exercising this option means buying at the price set in the past. Not exercising the option results in the investor paying the option fee. A great majority of scholars are of the opinion that Futures trading is not permitted in Islam.

iv. Short Selling:
Short selling is borrowing a stock from the brokerage firm and selling it in anticipation that the stock price will further go down. Once the prices are a bit stabilised the stock is purchased back to square up the sale transaction. Thus, the investor as a “shorter” keeps the difference. This transaction involves huge risk that almost has no upper limits. Moreover, from shariah point of view you cannot sell what you do not posses.

The author is PhD in Islamic Economics. At present he is Investment Consultant and Joint Editor Islamic Economics Bulletin. He can be contacted at: shariqnisar@yahoo.com

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