lecture 10

WEALTH PLANNING AND MANAGEMENT

• LECTURE 10

• TOPIC 5: INVESTMENT IN

SECURITIES

1

CONTENTS

• Introduction

• Types of Securities

• Price Determination

• Risk Elements

• Related Theories

• Laws Relating to Securities

• Questions for Revision

2

INTRODUCTION

• Securities are financial assets that are traded in the capital markets. Since the fluctuations in securities prices can be very volatile it is very attractive for people with surplus funds to buy and sell them hoping to get dividends and/or capital gains within a short time

• Issuers of securities on the other hand use their securities to raise funds for future expansion of their business. Governments too issue securities to raise funds for development projects.

3

The Islamic Equities Market• Going by the Shariah, equity financing would be the

preferred financing/investing technique. • Equity financing has no fixity of return.• Returns that are tied to the earnings of the

underlying business. • A risk-profile not detached from that of the business. • Thus, equity financing is very much profit and loss

sharing with all the business risks thrown in.

• Investment in a stock resembles the provision of Mudarabah financing.

The Islamic Equities Market• However, not all stocks listed in an exchange may be

acceptable from a shariah viewpoint.

• The need for a shariah evaluation of stocks and the identification of shariah compliant stock has led to the development of shariah filters, shariah indices, shariah compliant ETFs (Exchange Traded Funds) and an entire industry of Islamic Mutual Funds.

• All these have meant that there is an Islamic Equities Market

operating in parallel with the conventional equity market.

Components of an Islamic Equities Market

• What would constitute an Islamic Equities Market?– Stocks would be the basic component.– Islamic ETFs (Exchange Trade Funds)– Islamic REITs (Real Estate Investment Trusts)– Islamic Mutual Funds– Others like Islamic Private Equity Funds, Islamic

Structured Products etc.

TYPES OF SECURITIES

• There are two main types of securities namely:– Equity instruments

– Debt instruments

• The third type which is increasingly becoming popular is– The hybrids. Hybrids are those that have the

characteristics of both equity and debt.

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TYPES OF SECURITIES

• Difference between debt and equity:– In terms of claims– In terms of time

• Debt or borrowing is fixed in time i.e. it is terminal or has maturity and therefore is fixed in claim. This means that debt must be paid in full upon maturity. Once it matures the firm must pay the creditors the principle plus interest.

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TYPES OF SECURITIES

• Equity gives ownership to the holders. The holders own the firm less the firm’s obligations. i.e. equity is residual in claim. Whatever the firm makes belongs to the equity holders less its obligations.

• Secondly equity being ownership is not terminal and does not have a fixed maturity. It is perpetual.

10

TYPES OF SECURITIES

• The most common equity instrument is the common stock. As long as the stockholder has the shares he has a residual claim on the firm.

• The most common debt instrument is the bond. Generally bonds would provide holders a fixed annual or semi-annual interest payments (coupon payments) and full repayment of principal at maturity.

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TYPES OF SECURITIES

• Equity instruments – common stocks– Equity instruments represent ownership in the

company. A public listed company is jointly owned by its shareholders.

– All public listed companies are limited liability corporations. The shareholders liability is up to his investment. Since the corporation is a separate legal entity the shareholder is responsible for any losses up to his total investment.

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TYPES OF SECURITIES

– As investors, shareholders have certain rights:• Right to residual value of the firm

• Right to the portions of dividends if announced

• Right to vote in the AGM.

– Since dividend yield is low, shareholders have the chance to earn capital gain

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TYPES OF SECURITIES

• Some basic definitions of Common Stocks:– Authorised capital

– Issued (paid up) capital

– Par Value

– Treasury stocks (usually bought for senior management)

– Book Value per Share = Common Stockholders Equity / No. of Shares Outstanding

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TYPES OF SECURITIES

– Market Value of Firm = Market Price of Share X No. of Shares Outstanding

– Rights issue: sale of additional stock to existing shareholders usually to present shareholders at a slight discount

– Bonus issue: issue of additional stocks to existing shareholders for free

– Stock Dividends: where dividends are paid in terms of stocks rather than cash

– Earnings per share or EPS: is a key indicator used by shareholders and market participants

– P/E ratio or Price Earnings ratio: price per share divided by earnings per share

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Initial Public Offering (IPO)

• Initial Public Offering (IPO) Process is one when companies intend to sell stocks to the investing public– Must get approval from Securities Commission

to become a public listed company and have its shares listed in the Stock Exchange

– To get the approval the firm must have• Good track record of earnings• Good management • Fulfil basic statutory requirements

16

Initial Public Offering (IPO)

• After getting approval the firm will appoint a merchant bank to prepare for the IPO

• The initial issue price is determined by merchant bank based on the company’s financial health and track record, market conditions; investor sentiments etc.

• Post-listing prices are determined by market conditions• IPO market is considered as Primary market but once

listed it is traded in the Secondary market. This is because the IPO is normally offered to shareholders, corporations, etc. before it goes public through the stock market

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Screening of Stocks for Shariah Compliance

• Malaysia was the first Muslim country with a conventional stock market to have come up with a formal evaluation for shariah compliant stocks and a shariah stock index.

• Following this in 1999, Dow-Jones, the US based publisher of the Wall Street Journal and financial information provider, designed the Dow-Jones Islamic World Market Index (DJIWM).The DJIWM is a global index of shariah compliant stocks.

• In determining whether a stock is a shariah compliant a

screening procedure is used.

Shariah Screening of Stocks in Malaysia

• Shariah screening of listed stocks in Malaysia are based on parameters established by the Securities Commissions’, Shariah Advisory Council (SAC).

• The SAC was established by the Securities Commission (SC) in 1996.

• The SAC’s screening process as with the DJIWM begins with looks at two broad categories:

– i) The line of business or core business of the underlying company.

– ii) The company’s finances.

Stock Screening Process

• Halal Stocks and Shariah Index– Security Commission is responsible for

determining the Shariah compliant stocks and the Shariah Index through its very own Shariah Advisory Council (SAC)

– In principle the first level of screening is to focus on core business. Companies whose core businesses are Shariah compliant will form the universe.

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– Securities excluded are those involved in• Financial services based on riba; • Gambling and gaming• Manufacture or sale of non-halal products or related products; • Conventional insurance• Entertainment activities that are not permissible by Shariah • Manufacture or sale of tobacco-based products or related

products;• Stock broking or share-trading in Shariah non-compliant

securities;• Other activities deemed non-permissible by Shariah

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• The SAC also considers amount of interest income received by the company from conventional fixed deposits or other interest bearing financial instrument. In Addition dividends received from investment in shariah non-compliant securities are also considered in the analysis.

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• For companies with activities comprising both permissible and non-permissible elements the SAC uses two other criteria:– The public perception or image of the company

– The core activities of the company are important and considered maslahah (beneficial) and the non-permissible element is very small and involves matters such as umum balwah (common plight and difficult to avoid); ‘uruf (custom) and the rights of non-Muslim community which are accepted by Islam

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• While the above criteria are all subjective, in order to translate these subjective criteria into actionable filters, the SAC uses a two phase analysis/screening procedure. These being;

– Phase One :Quantitative Method– Phase Two :Qualitative Method

• Phase One: Quantitative Method– In phase one, the objective is to compute the percentage contribution

of non permissible activities to the company’s income and profit before tax. The income and profit before tax would be for the latest fiscal year as shown in the company’s Profit & Loss or Income Statement.


The computation of percentage is carried out as follows: Step 1 : Determine the earnings (Total Income/Revenue) and Profit

before tax of the company. Step 2 : Identify and measure the income/earnings and profit

before tax from the non permissible activities. Step 3 : Determine the percentages as follows:

(i) Earnings from non-halal activities X 100 Total Earnings of Firm

(ii) PBT from non-halal activities X 100 PBT all activities of firm

Step 4: Compare the percentage earnings and PBT with the two threshold level marks.

(see below)



• To determine the tolerable level or benchmark of mixed contributions from permissible and non-permissible activities, the SAC came out with four levels:– 5% benchmark – when the non-permissible are

clearly prohibited (riba; gambling; liquor; pork)

– 10% benchmark – involve element of umum balwah prohibited element affecting most people and difficult to avoid

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– 20% benchmark – mixed rental payment from Shariah non-compliant activities such as rental from premises used for gambling; sale of liquor etc

– 25% benchmark – activities that are generally permissible and beneficial (maslahah) but contains elements that may affect the Shariah status of these activities. Among these activities are hotel and resort; share trading; stock broking and others

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Phase Two: Qualitative Method

The qualitative method is essentially used on a case-by-case method. Again this is applicable for situations where the core activity of the company has importance and maslahah (benefit in general) to the ummah but includes a small element that may be haram. The non permissible activity could also be driven by custom or involve the rights of non-muslims. In analyzing such companies on a case-by-case basis, the SAC allows for threshold levels anywhere from 10% to 25%.



Since businesses are dynamic and conditions change rapidly, a company that passes the threshold at a point in time may exceed it at a future date. For example, a manufacturer of home appliances may have interest earnings below 5% currently but could exceed it at a later point. The opposite situation may also be possible. Thus, the SAC reviews the list periodically. An updated list is issued every 6 months. Currently about 85% of the listed stocks in Malaysia are deemed shariah compliant, based on the SAC criteria.

Shariah Compliant Listing• For companies with mixed contribution from Shariah permissible and

non-permissible activities, they are deemed Shariah-compliant should the following thresholds are complied with:

– Income from activities which are clearly prohibited (like conventional financial business, insurance, gambling, pork and alcohol is less than 5% of total turnover (TO) and profit before tax (PBT);

– Mixed rental income from Shariah non-compliant activities (like rental payments from premises used in gambling, sale of liquor) is less than 20% of total TO and PBT

– Interest income from fixed deposits and income from tobacco business is less than 10% of total TO and PBT;

– Income from hotel and resort business, share trading and stock broking of Shariah non-compliant stocks is less than 25% of total TO and PBT.

Stock Screening for the Dow Jones Islamic Index

• The stock screening procedure used by Dow Jones for its Islamic Index is more elaborate and tighter than that of Malaysia’s SAC. As is the case with the Malaysian criteria, there are two broad categories, the nature of the business and financial aspects.

• The Dow Jones criteria involves both financial statements, especially the Balance Sheet.

• Dow Jones begins with an initial step that involves eliminating stocks of all companies involved in an exhaustive list of activities. These are industries related to alcohol, liquor, pork related, conventional financial services (banking, insurance, merchant banking etc), hotels, entertainment (including cinema, music etc), tobacco, defense, weapons manufacturing etc. While this first step is qualitative, the second step involves the quantitative analysis of the firm’s financial ratios.

This numerical analysis is really aimed at two things, identify firms with “excessive” leverage in the capital structure and; identify firms with unacceptable levels of interest income. This is generally

done by applying the following three key ratios.

(i) Debt to Trailing Twelve Month Average Market Capitalization

Debt to TTMAMC

Computed as: =


Total Interest Bearing Debt12 months Average Market

Cap

X 100

Threshold: 33%

Thus, any firm with a Debt to TTMAMC exceeding 33% will be excluded. The rationale being that such a firm is paying a substantial portion of its earning as interest on its debts.


• (ii) Liquid Assets to TTMAMC

computed as: =

Threshold: 33%

• (iii) Receivables to TTMAMC computed as : =

X 100Cash deposits + Marketable Securities + Interest Bearing Instruments

TTMAMC

X 100Recievables +Trade Notes + Other receivablesTTMAMC

These latter two ratios are intended to capture the extent of interest earned by the firm from its liquid assets and its receivables. It is common practice in developed markets such as the US, for firms to charge an interest on all trade receivables outstanding beyond a certain period.

Threshold: 33%

Comparison of Stock Screening Techniques

• Though the philosophy and intended objective is the same, a comparison of the stock screening techniques of the Dow Jones Islamic Index (DJII) with that of the Malaysian SAC pints to obvious differences. The two key differences are;

– The tolerance for mixed businesses by the SAC.– The more stringent use of Balance Sheet based

financial ratios by Dow Jones.

• Malaysia’s SAC also does not evaluate a firm’s Balance Sheet. Thus, the firm’s capital structure and the extent of its financial leverage is not a consideration.

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• Since the SACs criteria is Malaysia specific, using a stringent filter will result in a smaller group of eligible stocks and therefore a much narrower investible spectrum for Muslim investors in Malaysia.

• One might ask, what is wrong with having a smaller but ‘purer’ group of investible stocks?

• There are several problems with this:– From a portfolio theory viewpoint, a smaller investible group of stocks restricts

diversification and limits the benefits of diversification.– One cannot form efficient portfolios or superior risk-return portfolios if the

group of investible stocks is restricted.– By implication one cannot be on the ‘optimal’ efficient frontier or get close to

such a frontier.

• As with everything else in economics, there is a trade off. The cost may be less efficient portfolios.

Comparison of Stock Screening Techniques


• Shariah compliant securities which are subsequently considered Shariah non-compliant:– If the price of the securities is more than its cost:

must sell immediately. If not the proceeds should go to charity

– If the price is lower than cost: then wait until the price is equal to cost and then sell. If dividends are declared during the holding period the dividend may be accepted

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Debt Instruments (bonds)

• Debt Instruments – are normally called bonds which are promissory notes that are traded in the market

• Bonds are categorised by the issuer; tenor; coupon type

• By issuer: government or corporate

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ISSUER TENOR

Long term Short term

Government Govt Bond Treasury bills

Corporations Corp Bond Commercial papers

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• Bonds also differ by coupon type– Coupon bonds pay periodic interest based on

coupons– Zero coupon bonds pay no interest on maturity

but only the face value. The purchaser will buy at discount.

– Interest can be fixed or floating. Floating interests are determined in reference to say KLIBOR + x%. If KLIBOR is 10% and x is 2 then for a bond of RM1000 the interest is RM120

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BONDS – Some basic definitions

• Par Value• Coupon rate• Sinking fund – amount paid by issuer periodically to

equal redemption amount• Coupon yield• Yield-to-maturity – total returns of bond• Duration of the bond• Unsecured bond• Collateralized bond• Speculative grade – lower quality bond

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Different types of bonds

• Callable bond – callable by issuer at a predetermined price before maturity. Investor is normally paid higher than straight bonds

• Convertible bond – allows holder to redeem at face value or convert it to a predetermined number of stocks

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Islamic Debt Securities

• Islamic Interbank Money markets (IIMM) was established in 1994. This is to allow Islamic banks to manage their liquidity and price discovery. Several new instruments were introduced– Mudharabah Interbank Investment (MII)

– Islamic Accepted Bills (IABs)

– Negotiable Islamic Debt Certificates (NIDC)

– Bank Negara Negotiable Notes (GII) and

– Other Islamic short term Private Debt Securities

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Key Islamic Money Market Instrumentsi) Government Investment Issue (GII) • To meet the need for a liquidity management instrument that is also

shariah compliant, the Malaysian Parliament passed the Government Investment Act in 1983. This act, enabled the Malaysian government to issue a non-interest bearing money market instrument, known as Government Investment Certificates (GIC) {now replaced with Government Investment Issues (GII)}. The GII was introduced in July 1983 under the concept of Qard al- Hasan.

• Since a Qard al- Hasan, based instrument would not have a predetermined fixed “face value” at maturity, it would not be suited for secondary market trading . Thus, beginning with a 15 June 2001, issue, GII’s are now issued under a new concept of of Bai Al-Inah. This, added depth and liquidity to the IIMM as the GII is now tradable in the secondary market via the concept of Bay ad- Dayn (debt trading).

ii) Bank Negara Negotiable Notes (BNNN)

• Bank Negara Negotiable Notes (BNNN) are a short-term, money market instrument issued by BNM. The underlying contract is that of Bai Al Inah. First introduced to the IIMM on 29 November 2000, It is now popularly traded in the secondary market. The price of the BNNN is determined on a discounted basis. Tenor is typically up to one year. The BNNN is designed as a liquidity management tool .

ii) Cagamas Mudharabah Bonds (Sukuk Mudarabah Cagamas)

• The Cagamas Mudharabah Bond, was introduced in March 1994 by Cagamas Berhad, the National Mortgage Corporation, to finance the purchase of Islamic housing debts from financial institutions. As the name suggests, the bond is structured using the concept of Mudharabah. Bondholders and Cagamas will share the profits accrued according to the predetermined profit-sharing ratios.

iv) Islamic Accepted Bills (IAB)

• The Islamic Accepted Bill (IAB), was introduced in 1991. The objective was to provide a shariah compliant instrument to conventional BAs, particularly for trade financing . The IAB is formulated on the Islamic principles of Al-Murabahah (deferred lump-sum sale or cost-plus). The secondary market trading of the instrument is based on Bai ad-Dayn (debt-trading).

• Murabahah is based on a cost-plus profit margin or mark up agreed to by both parties. Bai Al-Dayn refers to the sale of a debt arising from a trade transaction in the form of a deferred payment sale.

Islamic Debt Securities (Sukuk)

• Sukuk is a long term IDS whose underlying contractual framework could be a BBA; Murabahah; Istisna (purchase of manufactured products on order) or Ijarah (leasing). BBA is most popular and known as BAIDS but not popular among Middle East Shariah scholars

• The ijarah sukuk are more acceptable globally.

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Type of Sukuk, Characteristics, and Underlying Contracts Type of Sukuk Characteristics Underlying Contract

Pure Ijarah Sukuk Issued on stand-alone assets identified on the balance sheet.

The rental rates of returns on these Sukuk can be both fixed and floating.

Ijara

Hybrid/Pooled Sukuk The underlying pool of assets can comprise of Istisna’, Murabahah receivables as well as Ijarah

The return on these certificates can only be a pre-determined fixed rate of return.

Istisna’, Murabahah receivables and Ijarah.

Variable Rate Redeemable Sukuk or Musharakah Term Finance Certificates (MTFCs)

Redeemable in nature. Has relatively stable rate as compared to

dividend payouts. The floating rate of return on these

certificates would not depend on benchmarking with market references such as LIBOR but would instead be contingent on the firm’s balance sheet actualities.

Musharakah

Zero-coupon non-tradable Sukuk

The primary asset pools to be generated would be of the nature warranted by Istisna and installment purchase/sale contracts that would create debt obligations.

Non-tradable

Istisna’

Embedded Sukuk These could be Sukuk whether zero-coupon, pure-Ijara or hybrid.

Has embedded option to convert into other asset forms depending on specified conditions.

pure-Ijara or hybrid

Source: summarized from Tariq, 2004. Managing Financial Risks of Sukuk Structures.A dissertation at

Loughborough University, UK.

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Typical Sukuk Structure

SPV

INVESTORS

4

1

VENDOR/MANUFACTURER

COMPANY4

3

2

ASSET

SUKUK

$

Periodic payment

In order to have the required underlying sale/purchase of Islamic financing

modes, companies issuing sukuks typically have a Special Purpose Vehicle (SPV).

For example, suppose a company wants to finance the use of an asset, it can

do so by means of issuing a Sukuk Al Ijarah. The company would first establish

a bankruptcy remote SPV. The SPV issues the sukuks to investors and uses the

proceeds to buy the asset from the vendor / manufacturer. The SPV then

“leases” the asset to the company in return for periodic lease payments. The

lease payments received from the company are passed thru to investors as

their returns on the sukuk.

Other Sukuk Structures

• The are several different sukuk structures.• As the underlying contract changes, the structure changes. • In addition to straight forward “plain vanilla” structures,

there are increasingly exotic ones. • The need for exotic sukuk structures arises from the need

to; • avoid fixity in income/ cash flows• the need/ desire for specific cash flows• to alter risk profiles

Structure of An Asset Backed Securitization of sukuk

Mudarib (Originator)

SPV

Trustees

ABS Sukuk

Sukuk Investors

Asset

Payment $

1

5

Sukuk Sold 32

4

6

Payment for subscription $

Periodic payments

Note: Trustees are the ‘owners’ of the SPV which undertakes to service the sukuk.

Sukuk Vs Bonds

Item Bond Sukuk

Tenor Short, Medium and Long Term

Short and Med-Term (≤5 yrs)

Financing Category Debt

No debt but ownership of specific asset and its cash flows

Underlying Not necessary, unless collateralized

Necessary underlying asset, usually tangible asset

Claim Fixed in time, and amount

Ownership claim on specific asset and its cash- flows

Pricing Depends on rating, yield environment and demand (book-building)

Use of indicative yields-benchmarked on reference rates

Total Returns Fixed income (known/predetermined cash flows)

No guarantee in returns

Funding Purpose Unrestricted

Restricted for use in Shariah compliant assets, in a predetermined manner.

Hybrid Instruments

• Hybrids are instruments that have the features of both debt and equity. We shall consider four types only:

• Preference shares• Warrants / Transferable Subscription Rights

(TSR)• Call Warrants; and• Irredeemable Convertible Unsecured Loan

Stocks55

Preferred Stocks or Preference Shares

• Preferred stock is a true hybrid instrument. It has a par value, fixed dividend amounts and terminal maturity.

• In US it requires sinking funds which means a terminal maturity period

• Dividends on preferred stocks may be missed and are not tax deductible

56

Preferred Stocks or Preference Shares

• In Malaysia there are other variants– Participating Preferred Shares can have higher dividends if

company does well. Non-participating Preference Shares cannot get dividends

– Further, there are cumulative and non-cumulative Preference shares.

– For Cumulative Preference Shares, missed dividends must be made up by cumulating the dividends

– For Non-cumulative Preference Shares, missed dividends need not be made up.

57

Warrants/TransferableSubscription Rights (TSR)

• A warrant or TSR can be thought of as a long dated call option on the issuing company’s stock. They are typically attached to loan-stocks or bonds issued by a company. The idea is to make bonds or stocks more attractive and marketable. The warrants/TSRs can be detached from the bonds and traded separately in a secondary market (stock market)

• A warrant/TSR gives the holder the right but not obligation to buy the company’s stock at a predetermined market price

58

Warrants/TransferableSubscription Rights (TSR)

• Equity options will not dilute the ownership of the share holders but warrants when exercised dilutes the ownership. This is because when the warrant is exercised the company must issue a new stock to the warrant holders. This has effect on the price of warrants.

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Call Warrants vs TSR

• Call warrants are call options issued usually by merchant bank

• Does not dilute ownership

• To be exercised on maturity

• Stand alone and shorter period (18 months)

• TSR issued by company

• Dilutes ownership

• Can be exercised any time until maturity

• Attached to stock and for longer period (10 years)

60

Irredeemable ConvertibleUnsecured Loan Stock (ICULS)

• It is a fixed income debt instrument until converted into equity at some date or upon maturity

• Irredeemable for cash• Must be converted to underlying stock• Carry fixed interest coupons payable annually

or semi-annually• Unsecured• ICULS result in full dilution

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PRICE DETERMINATION

• Many factors influence price of stocks– Firm specific factors

– Industry specific factors

– Macro-economic factors

– Investor psychology

– Sentiments

– Performance of other regional stock markets

– International events etc. (Iraq war)

62

PRICE DETERMINATION

• Dividend Discount Model

• Zero Growth Model

• The Constant Growth Model

• The Accelerated Growth Model

63

DIVIDEND DISCOUNT METHOD (DDM)

DDM is based on the logic that a stock’s price today should equal the present value of future dividends that one could get by investing in the stock.

e.g. Suppose we buy stock A that gives dividend of RM2.00 per year. We plan to hold it for 3 years and expect the price at end of 3 years to be Rm60.00.

64


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69

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71

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73

Note that if K does not change over time the valueof the share increases at the same rate as the dividendgrowth. Since price increases gradually over time would the Investment return depend on how long you hold the stock?the answer is no. Please read page 195.

For accelerated growth model please read 199

RISK ELEMENTS• Business risk – uncertainty of income flows of firm’s• Financial risk – uncertainty form methods of financing• Liquidity risk- uncertainty in secondary market investment

or thinly traded assets• Currency risk – exchange rate risk• Country risk – political risk;

• tax risk e.g. Pakistan imposed 10% capital gain tax on shares held for less than 6 months; 7.5% holding between 6 months and 1 year.

• Bond risks and rating – different risk class and yield curves• Default risk – risk of non payment due bankruptcy• Interest rate risk – changes in bond prices• Inflation risk – loss in purchasing power

74

LAWS RELATING TO SECURITIES

• Banking AND financial Institutions Act 1989 (BAFIA)

• Securities Commission Act 1993

• Securities Industry Act 1983

• Securities Industries (Central Depositories) Act 1991

• Futures Industry Act 1993

75

REVISION QUESTIONS

• Compare and contrast the debt and equity instruments• What makes securities so attractive that shareholders are

willing to part with their ownership when they go public?

• Identify risk elements inherent in the investment in securities

• Explain the stock screening process adopted by the Shariah Advisory Council of the Securities Commission

• Explain how an ijarah sukuk is structured

76

THANK YOU

77

lecture 10

Economy & Finance

types of securities

equity financing

islamic private equity

equity instruments debt

introduction securities

types of securities

conventional equity

islamic equitiesmarket