Looking to capitalise on the rise of the emerging market consumer? Beware of the potential pitfalls.

With slowing growth in the developed world and success stories in their home markets, investors have naturally looked to emerging economies to identify the next Apple, Wal-Mart or McDonald’s. They are hoping to benefit from rising disposable income and, consequently, the increase in consumption of premium beer, branded clothing and countless other goods. This strategy could, with careful selection and diligence, be rewarding for investors.

But now, a word of caution: investors cannot invest in GDP; they have to invest in realbusinesses – either through equities or fixed income. The price they pay for those businesses is what determines investment returns. Strong growth translates into strong returns for investors only when the current valuation does not fully reflect that growth potential.

Some aspects of the investing environment to be aware of:

1. Rapidly growing economies do not necessarily lead to higher equity returns

In fact, history has shown there is virtually no correlation between real per capita GDP growth and the returns that investors can expect from stocks.

When a business invests in new plant and machinery to increase production, these investments appear as increases in GDP. Unfortunately, when capital investment in productive capacity occurs across an industry, it will lower the return on capital invested for all companies operating in that sector. This can drive profits lower and result in poor returns for investors.

In addition, within high-growth areas, it is not always obvious to see how the profit pool derived from revenue growth will accrue to businesses competing to serve emerging market consumers. High growth can be fragile, as illustrated by Nigeria, which has come full circle from a favourite investor destination to prevailing negative sentiment over its economic direction. Lower oil prices have exposed the weaknesses in the Nigerian economy: Nigeria’s All Share Index is down around 40% in US dollars since the collapse in oil prices.

2. Be aware of cyclical highs and lows within long-term trends and how this affects businesses

Strong growth prospects can result in capital flowing into listed assets.This causes currencies to strengthen, and inflation and interest rates to decrease, spurring credit – which in turn fuels consumption. Fiscal and current account deficits widen, and fixed investment typically falls.

Everything seems to run smoothly unless an external factor – such as an increase in rates by the US Federal Reserve or fears about a slowdown in China – causes things to unwind. Capital flows can head quickly for the door at the same time as the currency starts to weaken. If sales at consumer-related companies suddenly decrease, putting pressure on margins, this creates a double whammy for equity valuations. This has played out across many emerging markets, particularly economies such as Brazil, Indonesia, India, Turkey and South Africa.

3. Demographics can be a double-edged sword

Part of the attraction of many emerging markets is their young and growing populations – the so-called “youth bulge.” As young people leave school, become employed and have more money to spend, disposable income and consumption naturally rise. But this doesn’t come without risk – particularly if jobs are hard to find.

South Africa, for example, has one of the largest youth bulges in the world, with more than 28% of the population between the ages of 15 and 24 (versus 11% for an aging society such as Japan). But half of South Africans between ages 15 and 35 are unemployed. This may prove more risk, than opportunity.

It’s the price you pay that counts

Faster economic growth and favourable demographic tailwinds are appealing trends, but they do not translate automatically into higher equity returns. Economic growth and competition go together and determining the winners is not always obvious. The best way to achieve high absolute returns in any market is to pay the right price.