Original Question: Was doing my quarterly valuation revision when I realised that apples debt to asset ratio exceeded 33%. Then I read somewhere online that the alternative way to do this filtering is by using debt to market cap instead, which made it halal. Apparently it was stated that it is the preferred method by AAOIFI right now? So my question is, moving forward, are we expected to use that formula for all stock screenings? And will that be the accepted standard practice for all shariah-compliant funds? Thank you
Before answering your question on which ratio divisor (market cap vs total asset) to use for the screening, it is best first to understand the significant differences between divisors for the benefit of all the readers.
It may be summarised as follows:
Total Assets as Ratio Divisor (TA) – used by FTSE; MSCI; KMI-30 (Pakistan); SEC Malaysia:
The proponent of TA measurement advocates that TA measurement is more suitable and appropriate as the companies are fairly valued from the accounting standard capacity that is autonomous and is not influenced by any external markets or speculation. However, the MC proponent argues that TA reflects only historical value and not actual economic value. Furthermore, different accounting standard applications on inventories, revenue recognition, and depreciation will result in a different TA value (LIFO vs FIFO method).Hence, TA measurement will tend to undervalue the total worth of a company.
Market Capitalisation as Ration Divisor (MC) – used by S&P; Dow Jones; AAOIFI:
The proponent of MC advocates that MC measurement represents market valuation and uses the trailing average measure as a smoothing method to eliminate any seasonality effects, which will then reflect the real worth of a company. Also, MC allows continuous Shariah screening to be performed, unlike TA, where Shariah-compliancy can only be verified after the financial statements are published (i.e., annually). These contentions, however, are refuted by TA advocates. TA argues that MC does not inevitably represent the real worth of a company since MC is influenced by business cycle fluctuations and market price fluctuations, which means the MC tends to be higher during a bull market or during a high level of speculation. This is to say that MC value is mainly driven by sentiments about future cash flows and movement.
How do the different divisor ratios affect the stock universe sectors?
A study by Dr Shehab Marzban and Dr Mehmet Asutay on US and Japanese equities (stocks) proved that MC as a ratio divisor is more appropriate for screening the technology and health sectors. In contrast, TC as a ratio divisor is preferred for screening utility and industrial companies. In other words, the study showed that the stock universe (i.e., tech and health sectors) screened by MC has a superior return compared to the stock universe when screened by TA. Conversely, the stock universe (i.e., utility and industrial sectors) has a superior return when screened by TA compared to MC.
So, as a retail investor, which should we use (TA or MC)?
From the shariah perspective, you may choose either TA or MC since both are based on a credible opinion of the Muslim world scholars. However, it is recommended in Shariah to opt for the stocks that yield a lower percentage on the benchmark regardless if it is based on TA or MC. For example, a company that has a 10% of debt ratio is better than a company that has a 30% of debt ratio from the shariah perspective, even though they are both Shariah compliant. This is because the benchmark was devised based on necessity. And “necessity” in Shariah should be estimated according to their degree.
In addition, with the emergence of ESG information being easily accessible, it is encouraged for us to carefully consider the company’s impact on the environment and society. This is in line with our Shariah principles, and it is also proven by various studies that ESG positive rated companies have a superior return.
Allah knows best.
