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Home arrow Business & Finance arrow The art of RF (riba-free) Islamic banking and finance

RF Investment Discipline in Stocks

This layer represents a higher return, but also a higher risk. The RF guidelines for investing in the stock market was summarized in the previous chapter and detailed below.

This section will detail how the RF discipline and parameters for investing in stocks were developed for the first time in 1988 by your author and another pioneer; Dr. Saleh Jamil Malaikah, who is now one of the leading executives of one of the larger RF insurance companies (takaful); RUSD investment banks (rusdbank.com). In addition, many of the principles of RF financing and investing disciplines will be discussed in order to avoid participating in a stock market bubble that would waste the hard-earned wealth of the customers and investors involved.

The following are the RF disciplines and guidelines that were developed for RF investing in the stock markets.

Guidelines for RF Investing in the Stock Market

The spirit of investing according to the Judeo-Christian-Islamic Shari'aa law is to participate in equity investing and not in riba-based debt-type investing. Equity investing means owning equity in the company (companies). Riba-based debt investing means lending money to the company using a riba-based debt instrument, such as a direct loan, an interest-based (renting money) promissory note, or a predefined interest-based bond.

Investing in equities is highly encouraged by the law (Shari'aa). RF financing is all about equity participation in business activities that need financing. I was part of a group of scholars and experts who started investing according to the Judeo-Christian-Islamic Shari'aa law in 1988 in a $250 million stock portfolio. The portfolio performed better than the market averages both in total return and in its lower volatility. A number of guidelines were developed as early as 1988 to regulate RF investing in stocks based on the law (Shari'aa). The following is a list of these guidelines:

1. It is preferred to invest in companies that operate in local communities to generate economic growth and prosperity that would create new job opportunities, economic prosperity, peace, and harmony in the community.

2. Investing should be in socially responsible companies with a management dedicated to high ethical and moral standards with demonstrable results and track record.

3. Investing cannot be in companies that are involved directly or indirectly in divinely prohibited (haram) businesses, such as:

a. Alcoholic beverages, intoxicants, bars, nightclubs and associated activities, casinos, hotels that operate bars and casinos, airlines that serve alcohol on their planes and their first class and business class lounges, or promiscuous activities. For example, Walt Disney Company is known worldwide to be a company that provides family entertainment and theme parks, but it also owns movie divisions and trade names that may violate the promiscuous activities rule. Coca- Cola, in addition to its huge soft drinks business, has a thriving alcohol-related wine business. We could not invest in these companies.

b. Pork and pork products industries.

c. Tobacco products.

d. Interest-charging and/or -paying entities, such as banks, finance companies, payday check cashing companies, investment banks, insurance companies, and related businesses.

e. Any other unethical activities and businesses that are not fair to their employees and customers or are environmentally irresponsible.

4. The company's capital structure should have minimum debt. This has generated a lot of research and debate. The first issue was how to calculate the debt structure of the company. Should it be based on the company's book value or the company's market value? In the beginning, most scholars and Shari'aa committee members, including our pioneering group, preferred using the book value as a basis for calculating the debt as a percentage of total company capitalization and preferred to keep debt as low as possible. Later on, as Islamic mutual funds started to grow in the market, the regulation was relaxed to replace book value with market value. (Market value is obtained by multiplying the number of outstanding shares in the market into the closing share price on that day. Of course, in an inflated, overheated, and “bubbly” market, the market capitalization is so high that the debt on the company books when divided by that market value would give a misleading low debt to capitalization ratio.) This decision has allowed practitioners to expand the list of company stocks from which they can choose.

5. Equities in the U.S. market were screened as part of the research[1]; more than 10,000 companies were analyzed. The percentages of noncompli- ant stocks (in 2000) were:

Prohibited business line: 22 percent Excessive borrowing: 62 percent Excessive interest income: 8 percent Other exclusions: 3 percent

The total percentage of companies excluded was 95 percent. Out of 10,000 companies, only 500 were Shari'aa compliant.

6. The maximum debt allowed is 33 percent of the market capitalization, not the balance sheet capitalization (originally the ruling was to use the balance sheet capitalization).[2] However, in an RF regime using the Marking-to-Market Discipline and approach along with the Commodity Indexation Discipline discussed in Chapters 5 and 6, a corrector should be used that reflects the fiat-money-denominated overpriced assets in case a price-bubble is detected. For example, if oil price reaches $150 and, based on the Commodity Indexation Discipline, the normalized oil price after applying the Commodity Indexation Discipline by using a reference calibrating commodity like gold, silver, or a food staple should translate to a fair oil price of $50 to $70, that means the market valuation of that stock should be reduced to about one-third to one-half of its value, leading to a decision to sell out of the position or a portion of it (depending on the level of risk acceptance by the investor) to avoid participating in the bubble.

7. Company accounts receivables (A/R) should remain at 45 percent of total company assets.

8. Riba-based interest income should be less than 5 percent of total revenue.

9. Investment should be in actual stocks backed by an operating company and not just a paper index. Indexes that are not backed by tangible assets and that reflect the performance of an index based on prices are used in an RF regime only for measuring performance results.

These foundations for stock market investing according to the law (Shari'aa) were adopted by the Dow Jones Company to develop the Dow Jones Islamic Market Index (DJIMI).[3] Later, Standard & Poor's[4] introduced its own S&P Islamic Index. These indexes formed the bases for many Islamic mutual funds available in the stock market today. Amana Funds,[5] one of the most successful funds in general and the better RF fund in particular, developed its own parameters and screens. Its three funds, the Amana Income Fund, the Amana Growth Fund, and the Amana Developing World Fund, realized a four-star rating (2013) on the Morningstar rating system. The company was successful in getting some of the major brokering companies, like Charles Schwab and T. D. Waterhouse, to distribute the investment in its RF funds through its trustee capacity for custodianship over fund saved for retirement plans and for investments by general investors. This has increased the assets under management from approximately $65 million in the late 1990s to almost $1 billion in 2006 and over $2 billion in 2013.

  • [1] Saleh Jameel Malaikah, presentation at the LARIBA 2000 Seventh Annual Symposium on LARIBA (Islamic) Banking & Finance and Awards Dinner, Pasadena, California, April 29, 2000.
  • [2] The original opinion was to minimize the debt so that it would be as close to zero as possible. With the resulting small number of companies in which one can invest, the scholars and financial experts agreed to use analogy, with the conclusions used to limit the change in inheritance distribution to be a maximum of one-third. The scholars used this as a foundation to limit the debt of a company that can be invested in to one-third of the capital at first, then relaxed the ruling to be the company's market value on the market. Another major issue erupted with the minimum debt. The issue had to do with the dot-com and technology companies that were sizzling in the market in the late 1990s and early 2000s. These companies had essentially no debt and were included in the Islamic indexes. With the bursting of the dot-com bubble in 2000, many of these indexes lost a major percentage of their value. Islamic mutual funds that started in the late 1990s ended up losing more than 50 percent of their value.
  • [3] The Dow Jones Islamic Market Indexes (DJIMI) were introduced in 1999 as the first benchmarks to represent Islamic-compliant portfolios. Today, the series encompasses more than 70 indexes and remains the most comprehensive family of Islamic market measures. The indexes are maintained based on a stringent and published methodology. See the website for more information: djindexes.com/mdsidx/index.cfmPevent=showIslamic.
  • [4] The S&P Shari'aa index series is designed to offer investors a set of indices that are Shari'aa compliant. The S&P 500, the leading measure of the U.S. equity market, was one of the first S&P indices to offer a Shari'aa-compliant version. Modeled after its U.S. counterpart, the S&P Europe 350 and the S&P Japan 500 indices also offer their respective compliant versions. See the website for more information: www2.stan- dardandpoors.com/spf/pdf/index/Shariah_factsheet.pdf.
  • [5] Amana Mutual Funds Trust is designed to provide investment alternatives that are consistent with Islamic principles. Generally, Islamic principles require that investors share in profit and loss, that they receive no usury or interest, and that they do not invest in a business that is not permitted by Islamic principles. Some of the businesses not permitted are liquor, wine, casinos, pornography, insurance, gambling, pork processing, and interest-based banks or finance associations. The funds do not make any investments that pay interest. In accordance with Islamic principles, the funds shall not purchase bonds, debentures, or other interest-paying obligations of indebtedness. See the website for further information: amanafunds.com/amanx.html.
 
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