Shariah Compliance and Investment Behavior: Evidence from GCC Countries

ABSTRACT

The literature is largely silent on questions pertaining to the long-term physical asset investment behavior of Shariah-compliant (SC) firms. In this paper, using a unique dataset of SC firms constructed from the S&P’s Compustat Global database, we examine the investment patterns of Shariah-compliant (SC) versus non-Shariah-compliant (NSC) firms in six Gulf Cooperation Council (GCC) countries during the period of 2000 to 2014. We show that SC firms invest significantly less than NSC firms and the effect of reduced investment is stronger among firms with higher investment opportunities. This investment behavior is partly attributable to SC firms’ relatively limited access to capital given the tendency to keep leverage at a low level. This robust empirical finding continues to hold when we use various model specifications, alternative definitions of long-term physical investment, and different subsamples, and even when we factor in the endogenous nature of the choice to comply with Shariah.

KEYWORDS:

• Shariah Compliance
• investment
• capital structure
• Gulf Cooperation Council (GCC) countries

JEL:

• G30
• F30
• G15

Supplementary material

Supplemental data for this article can be accessed on the publisher’s website.

Notes

1. The only other corporate finance paper that we are aware of is by Akguc and Al Rahahleh (2018), who study the operating performance of Shariah-compliant versus non-Shariah-compliant firms and show that SC firms perform significantly better than NSC firms. Our research is distinct from a significant stream of research involving stock price implications of SC firms (for example, Ahmad and Ibrahim 2002; Arslan-Ayaydin, Boudt, and Raza 2018; Boudt, Raza, and Ashraf 2019; Hee 2002; Hussein 2004; Hussein and Omran 2005; Natarajan and Dharani 2012; Palac-McMiken 1997; Raza and Ashraf 2019; Reddy and Fu 2014; Setiawan and Oktariza 2013; Singh and Das 2013).

2. Due to their self-imposed constraint in regard to complying with Shariah, SC firms should and do invest more in real economic activities than NSC firm do. Real economic activities can be measured by investment in new capacity, acquisitions, new machinery, and new production facilities, etc. It is exactly for this reason that we capture all these investments in real assets with the various investment measures used herein (i.e., change in fixed assets, which are real non-financial investments, and CAPEX). We do not consider investment in financial assets. How these new real assets are financed is captured by our SC dummy given that capital structure is a binding constraint (i.e., constitutes a limit on interest-bearing debt).

3. The GCC common market serves as a perfect and unique environment for pursuing our research question in regard to establishing differences in the investment behavior of SC versus NSC firms. First, GCC countries are integrated through an economic and political union akin to the European Union and are similar in some important ways: they share a religion, oil is their principal source of revenue, and their government structures are comparable.

4. We use three measures to capture long-term investment: (1) gross investment, defined as an addition to gross fixed assets (change in fixed asset from time t-1 to t) scaled by total assets; (2) fixed asset growth, defined as the percentage change in fixed assets; and (3) CAPEX, defined as capital expenditures. CAPEX is included in fixed assets and is considered narrower in scope, as it does not include acquiring another firm’s physical assets through M&A.

5. In multiple studies, researchers have concluded that portfolio construction styles (e.g., Markov regime driven style allocation (MRDS), market capitalization weighted, fundamental value weighted, equal weighted, and low-risk weighted) affect the risk-return characteristics of Shariah-compliant investments (Arslan-Ayaydin, Boudt, and Raza 2018; Boudt, Raza, and Ashraf 2019; Raza and Ashraf 2019).

6. The data-screening process follows standard procedures established in the literature and is very similar to the methodology followed by Akguc and Al Rahahleh (2018).

7. These activities relate to such goods and services as alcohol, gambling, media and adult entertainment, conventional financial services, pork-related products, tobacco, and weapons. Qualitative screening for Shariah compliance was done with great care by manually reading each company’s detailed business descriptions to ensure that none was engaged in any of the “non-permissible” activities.

8. We classified firms as SC or NSC based on whether they violated any of the quantitative or qualitative criteria necessary for Shariah compliance (as detailed in this paper). For example, take Firm A and Firm B, which are both in the automotive industry, and thus have similar business models and are in competition with each other. From a qualitative perspective, neither firm violates the criteria for Shariah compliance because the business in which they are engaged is “permissible.” However, let us say that Firm A has 40% debt in its capital structure compared to Firm B’s 15%. In this case, Firm A would be classified as NSC as it exceeds the debt threshold, whereas Firm B would be classified as SC assuming all other quantitative criteria for Shariah compliance are satisfied as well. In our classification of SC vs. NSC, we do not make any claim about firms being Shariah-based (SB), i.e., the firm is governed based on Shariah law. Instead, we are interested only in Shariah-compliance, as it is very difficult to identify SB firms, given that industrial firms typically do not have a “Shariah board” within the firm. In SB firms, executives would even pass on profitable investment opportunities if pursuing them would mean violating Shariah law). As stated, we focus only on Shariah-compliant firms (i.e., firms that meet specific criteria under Shariah law) based on specific financial and non-financial firm characteristics.

9. Note the discrepancy between the total number of firm-year observations and unique firms and the SC versus NSC breakdown. This is due to firms changing status from SC to NSC and vice-versa. Overall, 1,148 firm-year observations or 130 unique firms did not change status: 363 firm-year observations (or 46 unique firms) were always Shariah-compliant and 509 firm-year observations (or 60 unique firms) were always non-Shariah compliant throughout our sample period of 2000 to 2014. On the other hand, 225 unique firms changed status: 1,326 Shariah-compliant firm-year observations and 1,150 non-Shariah-compliant firm-year observations.

10. Phan (2018) found that cash flow has a significant positive effect on investment. The result is consistent with Kadapakkam, Kumar, and Riddick (1998), who found that the cash flow-investment relation is the most sensitive for the largest firms and least sensitive for the smallest firms.

11. As we calculated the percentage change in PP&E from t-1 to t, year 2000 was excluded from the analysis.

12. According to Asker, Farre-Mensa, and Ljungqvist (2015, 10), “the investment literature proxies for a firm’s investment opportunities using either Tobin’s Q or sales growth […] but since private firms are not traded on a stock exchange, their market value is not observed. We thus favor sales growth, which can be constructed at the firm level for any firm, whether public or private.”

13. The terms “fixed asset growth” and “investment growth” are used interchangeably in this paper.

14. Our instrument choice closely follows that of Akguc and Al Rahahleh (2018), who use the sales share of SC firms in each industry as an instrument for the potentially endogenous public dummy.

15. This is also a meaningful effect that supports the “peer pressure” explanation. For example, assume that there are 50 firms in the two-digit SIC 55 Automotive Dealers & Service Stations Industry. Of these 50 firms, 30 are SC (60% of the total) and 20 are NSC. According to our estimation, if the percentage of SC firms in the two-digit SIC increases by 10% (from 60 to 66%), then the probability that the firm is SC increases by 7%. In other words, NSC firms in GCC countries are expected to know that investors might be concerned about Shariah-compliance status and the higher the percentage of SC firms in a two-digit SIC industry, the more likely it is that other firms will feel pressured to become SC and actually decide to acquire that status. Our first-stage regression in the 2SLS model supports this claim, as explained. Moreover, given that Shariah is the dominant form of law in GCC countries, as the number of SC-compliant firms increases in the industry, we expect a peer pressure effect to become evident whereby NSC firms consider it necessary to become SC.

16. Firms can move into our SC classification if they satisfy all the screening criteria in any given year. Likewise, firms can move out of the SC classification if they violate any one of the qualitative or quantitative criteria.