Franklin Templeton’s Dennis Lim discusses the approach to Sharia investments

Dennis Lim, senior managing director and portfolio manager in the Templeton Emerging Markets Group, has outlined the firm’s approach to Sharia investments, in mind of forecasts that the global Muslim population could hit 2.2 billion by 2030.

The end goal of Sharia-compliant equity investing is similar to many other equity investments (to seek capital gains and/or income), with an important constraint; If the main business of a company is not deemed compliant with Shariah law, a portfolio manager cannot purchase, hold or sell its shares, since investors are viewed as “partners” that share in the profits of the businesses.

What constitutes Sharia compliance?

While there is debate on the nuances of “compliance,” there are some general tenets that must be followed. For example, a company cannot be involved in prohibited activities such as gambling, or the manufacture and sale of alcohol, pork or other “haram” (forbidden) foodstuffs. In general, a company may not borrow money on interest or maintain excess assets in an interest-bearing account, because when it is financed on the basis of interest, funds employed in the business are considered to be impure. Therefore, companies providing financial services on interest or incurring significant debt would typically be excluded from a Shariah-compliant portfolio.

Of course, many companies don’t pass the test of compliance. The result is a significantly smaller pool of investible companies to choose from. All conventional banks, for example, are considered haram. That’s a challenge because in many emerging markets in particular, the banking sector is one of the biggest sectors in the market.

We rely on Sharia scholars to rule if a company is considered compliant, and the process is rather complex and time consuming. Our non-US domiciled Sharia portfolios are independently reviewed and endorsed by the Amanie International Shariah Supervisory Board, highly regarded for their extensive Sharia and technical understanding. The Amanie Scholars provide initial approval on investment objectives and strategy, as well as ongoing supervisory and monitoring services to ensure continuous adherence to internationally accepted Shariah principles and standards. If one of our holdings is no longer considered to be Shariah-compliant, we are required to sell that holding within a reasonable period of time.

I want to underscore that the principles of Sharia investing don’t necessarily prevent a company from operating efficiently or profitably. Some even believe the added discipline may be an advantage.

While it can be challenging to find Shariah-compliant opportunities, we are finding a lot of good companies in many areas of the world that fit within the parameters. In India, for example, there are thousands of listed companies and we regularly unearth what we believe could be potential Sharia gems there.

The screening process

Our team screens for opportunities from a potential universe of approximately 25,000 global securities. We evaluate companies on selected financial ratios according to prescribed algorithms, the quality of management, commitment to good corporate governance, etc. In keeping with the bottom-up investment philosophy that applies to all of our Templeton portfolios, we follow a rigorous, disciplined process that drills down to the business activities of every company on a granular level, then leverage analysis and insight from a worldwide network of locally-based risk management specialists. Once we have compiled our “Action List,” we then apply a second screen to weed out non-Sharia-compliant companies to end up with a list of Shariah-complaint stocks for our portfolio. Franklin Templeton boasts asset managers with expertise in Sharia-compliant strategies in the key Islamic finance centers of Singapore, Malaysia, the United Arab Emirates and Hong Kong; we are one of only a small number of foreign asset managers to have stand-alone operations in Malaysia.

For all our potential investments, the first step in the screening process is to identify companies that appear to be trading at a discount, based on our estimated projections for future intrinsic value. We then narrow down our potential investments through comprehensive fundamental and quantitative analysis on a company-by-company basis to assess long-term value. An important part of the process is to really understand the business, its management quality, ownership structure, corporate governance and commitment to creating shareholder value. Company visits are a key part of the process, where we tour facilities and interview management. The decision-making process is team-driven.

Sharia-compliant stocks form a subset of our emerging markets universe, but there is really no difference in how we select stocks for all our portfolios. After stocks have passed our rigorous process and end up on our Action List, we then screen our Action List to identify stocks that comply with the rules of Sharia investing. One thing we have noticed is that Shariah companies tend to have very efficient balance sheets. While other companies may have too much or too little capital, such companies would be screened out under Sharia investing rules.

The Sharia advisers are involved in every step of the process. They first provide us with a list of the stocks that pass their tests for Sharia compliance. During our company research, if our studies show a stock to be Shariah-compliant and that stock is not on the Sharia advisers’ list, we will discuss the reasons for exclusion with the them. Since companies are regularly tested for compliance with Sharia laws, it also means that stocks are constantly being added and removed because of changes to their balance sheets and income statements.

Portfolio maintenance

Once we’ve built a portfolio, we continually examine performance contributors/detractors. Our disciplined sell methodology may kick in when a stock price exceeds our estimation of fair value, when we think greater value potential exists in another security, or when a fundamental change occurs at a company that alters our forecasts or-in the case of Sharia portfolios-makes the company non-compliant. Our team regularly reviews portfolios for adherence to investment objectives and principles.

Through this process, we believe our non-US domiciled Sharia portfolios continually reflect Templeton Emerging Markets Group’s best investment ideas, and for the Islamic investor, can meet their unique requirements, too.


This comment was first published on the Mark Mobius blog:

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