The selection of Shariah-compliant equities is known for its distinct stock-evaluation process, which may offer a differentiated choice for portfolio diversification. On this front, investors can further harness the different styles of equity investing — such as value, growth or dividend-oriented Shariah stocks — to achieve enhanced results.

At Templeton Global Equity Group, we believe a value investing approach to Shariah-compliant equities has the potential to both stabilise portfolio performance and deliver excess returns during periods of volatility.

Below, we discuss the investment methodology and performance of Shariah global equities, as well as how our value-investing framework may potentially enhance the investment outcome of a Shariah equity portfolio.

Shariah-compliant equities: A brief overview

Islam provides a range of precepts and a moral code encompassing multiple aspects of human life. The source of this is Shariah law, which outlines a set of broad principles that Muslims are expected to follow. In a financial context, this broadly means recognising three principal categories of prohibitions: riba (interest), gharar (uncertainty or speculation) and haraam (activities that are prohibited).

In order to construct a Shariah-compliant portfolio, the aforementioned principles will likely result in screening out certain sectors and companies that may be held by non-Shariahcompliant portfolios. For instance, Shariah compliance means not investing in companies that are involved in the production or sale of alcohol, pork and other non-halal products, gambling, tobacco, weapons and defence, as well as various forms of entertainment.

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Additionally, one of the tenets of Islamic finance is the belief that money has no intrinsic value, effectively precluding the paying or receiving of interest or riba. Consequently, companies who generate profits from interest — such as traditional banks — are not considered compatible with Shariah.

Additionally, Shariah compliance may lead to a sharper focus on company fundamentals, particularly in terms of capital adequacy and debt levels. For instance, through quantitative screening, a Shariah equity strategy may help avoid highly leveraged companies exposed to excessive levels of interest-bearing debt. Additional examples are provided in the chart, “Criteria: Shariah equity strategy”.

https://s3.ap-southeast-1.amazonaws.com/www.theedgesingapore.com/public/usr/ash5m1/3383eb-Table-1-Criteria-for-Shariah-equity-strategy.JPG

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Guided by a stringent and rule-based stock selection process, a Shariah equity strategy may result in the construction of a portfolio of companies with potentially lower governance risks and stronger capital metrics. We believe this could result in sustained returns and better resilience amid volatility, which may have helped to partially explain the sustained growth of Shariah assets.

While the financial markets were disrupted by the pandemic, the global total assets under management (AUM) of Islamic funds — including Shariah-compliant money market and equity funds — grew a robust 34% to reach US$238 billion in 2021. By 2026, analysts project Islamic funds’ total AUM to hit US$416 billion ($554.3 billion).

This growth indicates a sustained market interest, both institutional and individual, in Shariah-compliant strategies, even amid the choppy market conditions of the Covid-19 pandemic. Concurrently, Shariah equity investing continues to maintain a healthy track record in terms of performance and stability, as we illustrate below.

Shariah equities and value investing: Outperformance amid volatility

One of the commonly used benchmarks for Shariah global equities is the MSCI ACWI Islamic Index. Since its inception in May 2007, the MSCI ACWI Islamic Index has achieved an annualised gross return of 5.54%, not far behind the 5.73% return recorded by the broader global benchmark — the MSCI ACWI Index — over the same period.

Importantly, the MSCI ACWI Islamic Index’s relative performance improved amid the market turbulence this past year. As shown in the table, “Islamic Index outperformed global benchmark in 2022”, over the one-year period ended Jan 31, 2023, the MSCI ACWI Islamic Index posted –3.95% in return, significantly ahead of the MSCI ACWI’s –7.54% return. In 2022, when the global equity market was roiled by interest rate hikes, recessionary fears and geopolitical uncertainties, the Islamic Index posted –12.80% versus –17.96% for the broader index. Over the three-year period ended Jan 31, 2023, which broadly encompasses the bulk of the Covid-19 pandemic, the MSCI ACWI Islamic Index again outperformed with 8.10% versus 7.33%, as indicated in the table.

https://s3.ap-southeast-1.amazonaws.com/www.theedgesingapore.com/public/usr/ash5m1/f0841f-Table-2-Comparing-Gross-Returns-of-MSCI-ACWI-Islamic-and-MSCI-ACWI-Indexes.JPG

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We believe this outperformance is partly due to the MSCI ACWI Islamic Index’s lack of exposure to financial stocks, which had broadly struggled in much of 2022, given the concerns around economic woes and credit risks. At the same time, the index still maintains a diverse enough exposure to capture returns from various cyclical and growth sectors, such as energy, healthcare and information technology.

In 2023, we believe this lack of financials exposure should continue to help Shariah equity investors shore up their portfolio resilience. Granted, the current rising yield environment — resulting from ongoing monetary policy tightening — may benefit banks in terms of interest-margin expansion, but macroeconomic headwinds look set to persist, and the sector may face further volatility going forward as investors potentially seek shelter from cyclical risks.

Delivering enduring value over the long term

With the MSCI ACWI Islamic Index’s track record and characteristics in mind, we believe a value-investing framework may potentially take a step further in delivering enhanced outcomes for a Shariah equity portfolio. Our value-investing approach does not merely rely on accounting metrics to determine what “cheap” stocks to invest. A diversified approach accounts for the full spectrum of value drivers, including:

• Price — the cost of a share in earnings, cash flow and assets;

• Quality — predictability, variability and risks associated with fundamentals; • Growth — both the rate of change and its sustainability/duration; and

• Event — tangible, fundamental and probable change likely to unlock value.

The result is a robust approach that can position us to identify high-quality and high growth companies with strong business fundamentals and unparalleled competitive advantages, while trading at a discount to their intrinsic worth. Importantly, these are the kind of companies that can better sustain earnings growth, generate cash flows and deliver shareholder returns throughout the entire economic cycle. With this approach, we aim to build a versatile portfolio that can offer “enduring value” and deliver alpha over the long term, without being whipsawed by the whims of the market.

In our view, a value-investing framework — with its emphasis on valuation discipline and company fundamentals — can synergise with the principles of Shariah equities to potentially improve the results of stock-picking and portfolio positioning. It is a double-barrelled approach that may prove rewarding for investors interested in Shariah-compliant equity strategies, especially as the market navigates the challenging landscape of monetary policy tightening and economic slowdown.

Alan Chua is portfolio manager and research analyst at Templeton Global Equity Group. William Chang is institutional portfolio manager at Templeton Global Equity Group

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