How to Buy Halal Stocks – Stock Screening Method | IFG

How to Buy Halal Stocks – Stock Screening Method | IFG Featured Image

12 min read




Mustafa Khan

- The Criteria
- Practical Application
- Investment musings and conclusions

IFG has been inundated with requests to shed some light on how exactly Muslims can go about analysing whether a particular share is halal to invest in – this article will enable you to do that. We can’t promise that this will be an easy read, but we are keen to empower you with the tools you need to do help you ascertain whether or not a company is sharia compliant or not.

We understand that many of you will also want to go a bit further than this article, and have a guided course in which we explain with video tutorials all of the steps below. We also delve into the intricacies of what to do when it comes to grey areas.  Check out our exclusive sharia screening course

We also offer a Halal stock screener within our Track feature. All you need to do is input your stocks and you will receive insights on any that are not compliant

If you want to go it alone, we’ve laid out everything for you below. 

The Criteria

There are broadly five key criteria that a company must pass in order to be considered a sharia-compliant halal investment. These are screening criteria according to Mufti Taqi Usmani, which must be met in order for a company’s shares to be a halal Islamic investment.

The Business

The first and perhaps most obvious is simply the business of the investee company. Your average Muslim, or even non-Muslim in today’s wonderfully diverse environment, can tell you that it is haram to invest in a company whose main business is alcohol, gambling, pork, night club activities, etc. These are things that we can unequivocally say are haram to invest in without the need for detailed analysis. So the main business of the company cannot violate the Sharia, which rules out many obvious choices like alcohol immediately.

There is a slightly greyer area of companies in the financial services sector such as banks and insurers or even, say, stock brokers themselves. These are probably best judged on a case-by-case basis rather than having a blanket policy, but the safest option with grey areas is to avoid.

Additionally, the capital planning of the company must have been executed already; meaning the assets are existent and business processes are ongoing. Put simply, this means that the plans to buy machinery, factories have been carried out; so you are not simply investing in the ‘idea’ of these assets, they are now tangible and the business has started running.

So if you can put a tick in this section, you carry on to the second criterion.

Income from non-sharia compliant investments

What about (as it is in very many cases), when the overall business is halal, but the company also has haram elements involved in the running of it? This can be because they have an element of interest-based income or they are borrowing on interest, for example. This is known as income from non-Sharia compliant investments.

The rule of thumb is that the income from these Haram investments cannot exceed 5% of the gross revenue of the company. So there are two figures to check here: 1) income from non-sharia compliant investments; 2) gross revenue.

The investor has to check the annual reports to determine what percentage of haram income was received and consequently give away that same percentage of his profits to charity. And the final condition is that the investor must voice his opposition to these Haram activities, either written or orally, perhaps at the annual shareholder meeting.

Side Note:
The process we just mentioned of an investor giving away a portion of his profits to charity is known as purification. It is important to define what we mean by ‘profits’. In this scenario, we are describing it as both dividends that the stock yields, and also capital gain-which is the price of the share increasing. The reason I highlight it is that there is some difference of opinion among scholars as to whether purification is done on solely on dividends or also on capital gain.

The case for purification on capital gain is because some contend that the market price of the share reflects an element of the benefit from haram activities of a company. However, the fact that we even bought the shares shows that the majority of the company assets are halal which means that the share price is based on the large proportion of halal assets and not on the small ignorable quantity of assets from haram income. Thus purification on capital gain is arguably not needed. However, the safest option is just to purify both dividends and your capital gain on a sale.

Interest-bearing debt to total assets

The third criteria is interest-bearing debt to total assets of the company. The total interest bearing debt should not exceed 33% of total assets. This metric is quite simple to remember, but what is interesting about this one is that extremely successful (non-Muslim) investors also apply this criteria to their stock screens. In fact they used exactly the same percentage of 33% acceptable debt, as opined here by Mufti Taqi. The likes of Benjamin Graham, widely considered as one of the greatest investors of the 20th century, emphasised this metric very strongly in his famous book ‘The Intelligent Investor’. The same principles regarding debt financing were emulated by his student, the famous Warren Buffett, who is still alive today.

The specific amount of interest-bearing debt might not always be made explicitly clear on the accounts. Sometimes, for instance, ‘borrowings’ as listed on the accounts might be interest-free loans from directors. It is therefore vital to check the supplemental notes to the accounts which will break things down further and tell you specifically.

Let’s look at an example from a company that’s been in the news a lot over the last week or so. This is from their last annual accounts:

sharia screen halal investmen

You can see firstly that their borrowings stood at £688.7m (£96.7m+ £592m). You can also see that it points you in the direction of ’19’ which stands for ‘note 19’ (of the accounts). ‘Current liabilities’ means debts due in the next 12 months and non-current liabilities are those due beyond that time frame.

Once you scroll all the way down to note 19, you will find the breakdown of borrowings as follows:

We can see from the above that all of their borrowings are interest-bearing. Since we not sure whether the finance lease was structured in a sharia-compliant manner, we will add this to interest-bearing borrowings too. We are also assuming the overdraft carries an interest charge.

Carillion’s total assets are in the accounts as £4.43bn. Thus, we calculate the percentage as follows: (£688.7m/£4.43bn)*100 = 15.5%.

Since this figure is less than 33%, Carillion is fine on this front.

n.b. this article is only correct at the time of publication – of course numbers will change over time.

Illiquid assets to total assets ratio

Moving onto the illiquid assets to total assets ratio; any asset that can’t be converted into cash very quickly (close to prevailing market prices), is said to be illiquid. A common example is real estate, so a company might have office blocks or factories etc. In the circumstance where they are undercapitalised, a company might have to resort to a fire sale of illiquid assets, where they are sold well below market prices. This example helps us demonstrate how illiquid assets are very hard to sell quickly, but also close to the market price.

There are varying opinions as to what percentage illiquid assets should constitute of total assets. You might be wondering why this is an issue for sharia compliance: well if a company has purely liquid assets, let’s say just £5m of cash in the bank and no other assets, it can Islamically only be sold at par value. Here, Mufti Taqi is of the opinion that the illiquid assets should be at least 20% of total assets.

Illiquid assets are usually found on the balance sheet of the accounts and include things like goodwill, property, plant and equipment, intangible assets, and basically anything that you think fits the definition of illiquid according to the above. To get the percentage, simply add up the figures for illiquid assets, divide by total assets, and multiply by 100. You want it to be 20% or more.

Net liquid assets v market capitalisation

The final criteria is Net Liquid Assets Vs. Market Capitalisation.

This criteria is one that is rarely actually relevant but we cover here for completeness.

Before I describe what the criteria is, let me illustrate the logic behind the criteria. Firstly, Net Liquid Assets = Total Assets – (Tangible Fixed Assets + Inventory) – Liabilities. To keep things simple, let’s think of net liquid assets as cash. In Shariah, it is not permissible to exchange money for less or more money (as we’ve seen in criterion 4). For example it is not allowed that I purchase a box for 50 pounds, when it contains 70 pounds inside. This is essentially what is happening if the value of the net liquid assets exceeds the market capitalisation of a company, where you end up buying a share which actually represents more money than what you actually paid to buy that share.

So the criteria given by Mufti Taqi, is that the value of the net liquid assets per share should not exceed the market price per share, or to avoid an extra calculation, net liquid assets should not exceed the market capitalisation. It is possible that this could happen, for example with a holding company which has purely liquid assets. But for the most part, the companies we’ll be covering in the FTSE 100 shouldn’t have this problem.

Practical Application

Now, as promised, let us apply these criteria to a company.

Rio Tinto is a multinational mining company. I am not going to go into detail about the company itself, but briefly, this company is a leading global mining and metals group that focuses on finding, mining, processing and marketing the Earth’s mineral resources. If you want some practical experience, you can open the accounts yourself here.

Step 1 – The business

We can quickly deduce that the main business of this company doesn’t go against the Shariah, as mining and processing natural resources are acceptable activities.

Step 2 – income from non-sharia compliant investments

Let’s look at the annual report 2016 to check income from non-shariah-compliant investments. We can see in the income statement (p.110 of the annual report) that finance items (anything interest related) adds up to $83m, which as a proportion of the $33.781bn of revenues is 0.246% – much less than the 5% requirement of income from interest.

Step 3 – interest-bearing debt to total assets ratio

Turning to the balance sheet (p.113), we want to look at total debt of the company. For Rio Tinto, the total assets figure is $89.263bn.

Most annual reports have a current liabilities and long-term liabilities section. We consider both, as the short-term liabilities of the previous year give us a guide for short term liabilities this year. In this case Rio Tinto has $18.392bn in interest-bearing debt and $89.263bn in total assets which gives a debt/asset percentage of 20.6%% which is less than 33% so we are still fine.

So far, so good.

Step 4 – Illiquid assets to total assets ratio

Still looking at the balance sheet we can see that illiquid assets are valued at $66.165bn (by adding up property, plant, equipment, goodwill, intangible assets and inventories). They make up 74.1% of total assets ($89.263bn), which is greater than 20% so we give another criteria the green light.

Step 5 – net liquid assets v market capitalisation

Finally we consider net liquid assets which are $15.086bn. In this scenario, we consider ‘liquid’ to be current assets, as these are almost certain to be converted into cash in the short term with no loss in value. We need to remember that liquidity is on scale, with things like cash being very liquid and real estate as fairly illiquid. This $15.086bn is below the market capitalisation of $57.866bn.

Thus, all conditions are met, and it is permissible to invest in this company.

Summarised this looks like:

Activity: Mining, processing, marketing
Income from haram sources (must be <5%): 0.246%
Illiquid assets to total assets (must be >20%): 69.4%
Net liquid assets to market cap: 15.086bn to 57.89bn therefore fine
Zakatable assets as a percentage of total assets 21.159bn of zakatable assets out of total assets 89.263bn is 23.7% .

Zakatable assets is not something we have discussed. A quick example to show how we actually use the 23.7% figure. Say your shares are worth $100. Then $23.70 are zakatable, so you simply work out 2.5% of $23.70, and give that to charity.

But how to actually work out zakatable business assets?

Firstly, we need to make a distinction between your intentions when buying shares. Are you buying them as a long-term investment for dividends or are you buying them with the sole intention of reselling them for a higher price in the short term?

In the latter case, it is generally accepted that your entire shareholding is subject to 2.5% Zakat.

This is because your shares themselves are assets you want to sell for profit. So if you bought £1000 of shares and the market value at the time your zakat is due is £1250, you will pay zakat on the £1250 even if you have not sold. So here, you would pay 2.5% of £1250 which is £31.25.

In the former case, i.e. you are purchasing shares as a long term investment, you can actually go ahead and work out zakatable business assets, to lower the amount of Zakat paid each year.

These assets include cash, inventories, strong debts (money owed to the business which is likely to be repaid) and raw materials.

There is no need to overly worry about calculating this figure exactly, and in Rio Tinto’s case I simply went to the balance sheet, added all current assets and some of the non-current assets. The non-current assets which I picked were: inventories, deferred tax assets, trade and other receivables, tax recoverable, other financial assets and assets of disposal groups held for sale. This is how I arrived at the figure of $21.159bn. To summarise: current assets + some non-current assets + assets of disposal groups held for sale.

Slightly confusing? Not to worry; if you don’t want to get bogged down with balance sheet calculations, it is also permissible to simply take 25% of the market value of your share holdings, and pay 2.5% on that. To illustrate what I mean, say you have $100 worth of shares, you can take $25 to be zakatable. So you need to work out 2.5% of $25 and give that to charity.

Investment Musings

So, would I invest? My decision on this company would probably be to buy, as I see capital gains in the long term, maybe 1-2 years. Rio Tinto had a sudden turn in fortune in 2015, with the rout in the commodity markets, which drove down prices due to an oversupply. This was partly because of irrational fears that China was consuming most of the world’s resources. It is important to remember that the bad results were largely due to macroeconomic results, and not due to company inefficiencies and operational mishaps. The company did quite well as compared to some of its competitors, in pulling through. It massively reduced capital expenditure and has managed to release a positive net income in the 2016 half year statement. Although dividend payments have been cut, in the long term there is a good chance that Rio Tinto will manage to recover and post higher net income. In one way, the recent crisis has been good as it has allowed the company to focus even more on efficiency and offers good future growth prospects. Downturns can often weed out the most efficient companies, which makes them attractive propositions on the other side.

These are just my own brief musings without a more detailed look, and I’ll leave it to you to do your own due diligence before/if you invest. This should not be taken as advice in any way.

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