Munich Personal RePEc Archive

Analysis of Stock Screening Principles in Islamic Mutual Funds Industry

Shaikh, Salman (2010): Analysis of Stock Screening Principles in Islamic Mutual Funds Industry.

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Abstract

According to Islamic principles for investments in stocks, market price per share should be greater than net liquid assets per share. It may suggest that this principle restricts investments in the stock of liquid companies. Creditors prefer a favorable Current and Quick ratio but shareholders are not exactly happy when the company has immense liquidity. Excess liquidity implies the company has excess funds, but it has not invested them in its operations fully. There is a trade-off between profitability and liquidity companies have to make. Cash equivalents and marketable securities usually yield a return that is negative in real terms in most developing countries.

The interests of creditors are managed by another principle that if a company has financed a portion of its assets with interest bearing debt; then, the interest bearing debt should not be more than 40%. Debt financing is a double-edge sword. Leveraged companies can magnify their returns in booms, but in slumps, they lose the edge and can even go bankrupt and make both their shareholders and creditors suffer. Debt financing results in a zero-sum game in which at least one stakeholder i.e. shareholders or creditors suffer. Equity financing ensures normal returns in booms and survival in slumps. Therefore, the company will not be squeezed of liquidity as interest expense as an ‘autonomous expense’ will not feature as a significant portion of total operating expenses.

But, how to become shariah compliant is a logical question to ask at this point. There are certain principles that need to be followed to become shariah compliant. This paper will discuss how a company can become a shariah compliant KMI-30 company by using economic models and established deductive knowledge in Economic, Finance and Portfolio theory.

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