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From Mark Mobius Blog, Franklin Templeton,

For some, the only guiding rule they have for investing is to grow their assets. For others, the rules are more complicated. Specifically in the Muslim world, demand has been growing for investments compliant with Islamic law (Sharia or Shariah) which adhere to a set of religious beliefs and principles. Considering the global Muslim population is expected to grow to 2.2 billion by 2030, representing more than a third of the world’s total population¹, I expect rising demand for Shariah-compliant investment vehicles to continue.

To explore the world of Shariah investing I’ve invited Dennis Lim, our Senior Managing Director and Portfolio Manager, Templeton Emerging Markets Group, to share his thoughts on how our team conducts its due diligence to appeal to an audience seeking out these particular equity-based investments.

Franklin Templeton Distributors Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products only. The following discussion with Dennis Lim pertains to non-U.S. products and services not available in all jurisdictions, including to U.S. residents, and offered outside the U.S. by other Franklin Templeton Investments’ affiliates and/or their distributors as local legislation permits. Please consult your professional adviser for information on the availability of products and services in your jurisdiction.

Dennis Lim

The end goal of Shariah-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 Shariah 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 Shariah scholars to rule if a company is considered compliant, and the process is rather complex and time consuming. Our non-US domiciled Shariah portfolios are independently reviewed and endorsed by the Amanie International Shariah Supervisory Board, highly regarded for their extensive Shariah 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 Shariah 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 Shariah 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-Shariah-compliant companies to end up with a list of Shariah-complaint stocks for our portfolio. Franklin Templeton boasts asset managers with expertise in Shariah-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.

Shariah-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 Shariah 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 Shariah investing rules.

The Shariah advisors are involved in every step of the process. They first provide us with a list of the stocks that pass their tests for Shariah compliance. During our company research, if our studies show a stock to be Shariah-compliant and that stock is not on the Shariah advisors’ list, we will discuss the reasons for exclusion with the them. Since companies are regularly tested for compliance with Shariah 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 Shariah 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 Shariah portfolios continually reflect Templeton Emerging Markets Group’s best investment ideas, and for the Islamic investor, can meet their unique requirements, too.

Important Legal Language

All investments involve risks, including possible loss of principal. Investment strategies that focus on Shariah-compliant investments may be subject to greater risk of value fluctuation than a more diversified strategy. Shariah-compliant investments are subject to additional risks, such as Shariah compliance risk, which is the risk that the performance of a strategy focusing on Shariah-compliant investments may be lower than that of other strategies that do not seek to strictly comply with Shariah principles, since Shariah principles may require a Shariah-compliant strategy to dispose of, or may prevent it from acquiring, certain well-performing securities. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.

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