To identify Shariah-compliant stocks, Zoya applies the shariah standards determined by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) under the guidance of our shariah advisor, Sheikh Joe Bradford. AAOIFI is an international nonprofit organization based in Bahrain that develops uniform standards and training for the Islamic finance industry. You can learn more about them here.
How do you apply them?
In order to ensure that the stocks we present in Zoya are compliant, we run two screens: first a business activities screen, then a financial screen.
The business activities screen identifies how a company earns its money. Companies that provide products or services that are prohibited in Islam — such as alcohol, gambling, pornography, and interest-based financial products — are an obvious no-no. We then screen for secondary activities, things that may not be outright haram (impermissible) but are frowned upon such as music/media, advertising, weapons, and tobacco. We track how much revenue is earned by selling products like these so that you can determine the level you are comfortable with in your portfolio.
There are cases where a company’s core business is perfectly fine, but a small amount of revenue is earned through haram products. An example would be an airlines that sells alcohol on its flights or a supermarket that sells pork. Most scholars tend to agree that no more than 5% of revenue can come from impermissible means. The compliance report in the Zoya app will list the non-Islamic revenue percentage broken down by individual segments, as they are reported on the company’s annual SEC filings (Form 10-K). Our screening engine will then flag them as either non-compliant or questionable.
For the financial screens, we identify interest-bearing debt, interest-bearing securities, and liquidity.
Interest-bearing debt refers to the loans a company takes out to fund their business operations. To be acceptable, a company’s debt-to-market cap ratio can be no higher than 30%. In other words, a company’s debt can only be roughly one-third of its market value, or market capitalization. The market cap is simply the stock price multiplied by the number of shares outstanding. Why is this important? Because the best hedge against volatility is a well-capitalized company, and companies with low debt and less liabilities will be more stable.
Interest-bearing debt = Total debt / Market Cap
Interest-bearing securities refer to a company’s investments in assets that generate interest. This also cannot exceed 30% of the market cap.
Interest-bearing securities = (Cash + Cash Equivalents + Deposits) / Market Cap
Lastly, liquidity refers to a company’s cash, cash equivalents, and accounts receivable (i.e. money owed to the firm by its customers). The total liquidity may not exceed 70% of total assets in order to be an acceptable investment. Anything higher can be considered hoarding.
Liquidity = (Cash + Cash Equivalents + Accounts Receivable) / Total Assets
What about other screening methodologies?
There are a handful of Shariah-compliance screening standards out there — no single standard is used by all Islamic finance companies or data providers. We plan to support these other standards within our app very soon.