For years, Montgomery Investment Management chief financial officer Roger Montgomery sat on television or radio panels and rolled his eyes as other experts declared that easy gains on the stock market were now over.
But now he finally agrees with those cynics.
"In recent years investors have made substantial gains from equities, but a close look at the driving force behind those gains is likely to reveal investors won because the tide was rising," he said on the Montgomery blog.
"Sure, many companies grew their earnings too but there were a huge number of companies whose share prices went parabolic despite the absence of earnings."
Once central banks do indeed raise interest rates multiple times this year, as expected, the party will be well and truly officially over.
"A rising tide does indeed lift all boats, but don't mistake a rising tide for genius, or so the axiom goes," said Montgomery.
"Investors can kiss goodbye the easy wins resulting from shares simply becoming more popular, and that rising popularity being reflected in ever-expanding price-to-earnings multiples."
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Not everyone has woken up yet
Montgomery is disturbed that not all investors seem to have realised yet that ASX shares are right now in a transition to an era of lower PE ratios.
"Rates are rising. And while I think rates will rise by less than the most bearish forecasts, the impact on PEs is already underway," he said.
"Plenty of investors haven't yet worked that out and this can be seen in the steep gains for almost all equities amid the hope and talk of peace in Ukraine."
Indeed, the S&P/ASX 200 Index (ASX: XJO) rose 6.4% in March despite all the inflation and geopolitical worries.
High quality growth shares
So what type of ASX shares should investors target for this new era?
Montgomery recommended seeking exposure to "high quality growth".
This is because if market-wide PE ratios are deflating, the only way to maintain or raise the share price is to grow earnings significantly.
"If a company, with earnings of $10 per share, sees its PE of 35 times fall to 25 times, the share price will decline 28%, from $350 down to $250," said Montgomery.
"Plenty of high-quality growth companies have experienced this, and worse. And that represents a new opportunity."
However, if this hypothetical company can grow its earnings 40% to $14 per share, the stock price will be maintained at $350.
"The work investors need to undertake now is to uncover those companies able to grow," said Montgomery.
"One place to look is among those companies enjoying structural or megatrend tailwinds. And if among those companies you also find a capital light and highly profitable business with net cash on the balance sheet, more power to you."
One great example is a business that enjoys "inelastic demand", namely Microsoft Corporation (NASDAQ: MSFT).
"Nobody is going to cut their subscription to Microsoft Office just because Jerome Powell said interest rates are going up, or because Putin decides to invade Ukraine," Montgomery said.
"Inelastic services like Microsoft Office are entrenched in the daily systems of hundreds of millions of businesses and individuals. That durability provides Microsoft low cyclicality, higher profitability, stable, recurring and growing cash flows and little or no need for debt."
The ASX shares to avoid are businesses that are capital-intensive, low growth, mature, cyclical, or geared.
Other warning signs are companies with "lumpy contract-type revenues" and those relying on discretionary spending.
"Avoid… those companies playing in the revolving door of capital – paying out cash they need later as dividends today and subsequently raising dilutive capital to replace it."
Icing on the cake
If the rise in interest rates has the desired effect of suppressing inflation, those investors holding quality growth will be cheering even more.
"What follows is disinflation — and in a disinflationary environment, when the economy is still growing, PEs expand again," said Montgomery.
"That would be icing on the cake for investors who heed the suggestion to invest in quality growth after share prices have been slammed by contracting PEs."
