Most investors and executives want a piece of the booming Asian market for the right reasons. With vigorous growth in the region, getting into China, India, and other countries should position companies well for the expected groundswell of shareholder value. And for many sectors, such as high technology and manufacturing, the advantages of going to Asia, particularly China, have so changed the competitive dynamics that there's little choice but to join the rush.

But the decision to go to Asia can be unsound as well. Many executives who invest in China or India believe that these markets will suddenly kick-start stalled growth at home, reviving their companies' sagging prospects. On that score, we think caution is in order, for two reasons.

First, from a growth perspective, the returns from investments in Asia just aren't going to be that large—at least over the next decade. Even under optimistic ten-year forecasts for these fast-growth markets, in most industries the real value for shareholders will still lie in the United States and Europe (Exhibit 1).

At current growth rates, corporate investment in Asia¹ will not have a tremendous impact on the short- or medium-term growth and profitability of multinationals. One Western conglomerate, for example, recently announced its goal to double its revenues from China over the next five years—a 15 percent annualized rate of growth. That figure may sound weighty, but since China currently represents only 5 percent of the company's revenues, the impact would increase the conglomerate's overall growth rate by a mere 0.6 percent.

Second, one useful way of looking at Asia is from a capital markets perspective. Corporations can learn what to expect upon entering the Asian market by analyzing the region's listed companies in terms of their valuation and underlying performance. From this angle, the Asian market contains complications that any company would be wise to consider.

While some companies have demonstrated high growth and profit margins, for example, Asian companies trade at a consistent discount compared with their US and European counterparts—the sole exception being Chinese stocks on the Shanghai and Shenzhen exchanges, many of which are also tracked by the IBES index² (Exhibit 2). Investors could well be skeptical of these companies, since their high valuations reflect not only their underlying strength but also the immaturity of the markets and a lack of investment alternatives in China. For some companies tracked by the IBES and also traded in Hong Kong, where investors enjoy more investment options, the Hong Kong price can be a half to a third lower than the price in mainland China.

So if a direct link exists between a company's long-term market valuation and its underlying growth, why do Asian companies suffer from valuations that are considerably lower than those in many other parts of the world? Several reasons are apparent.

Capital returns. Despite high margins in most sectors and product markets, the average return on capital in the four northern Asian markets we analyzed is well below the US and European average (Exhibit 3). That's caused in part by poor discipline. Banks, through their uneven underwriting and their high levels of nonperforming loans, allocate capital in an inefficient manner. Companies that allocate their capital better than the average Asian corporation does might see an opportunity, but the fact that Asian competitors can operate with lower average capital returns could also pose a threat to them. Family ownership of companies also inhibits efficient allocation of capital.

Governance. Companies looking to compete directly in Asian markets or to enter them through joint ventures and other partnerships should keep in mind that Asian companies have not been particularly kind to minority and public shareholders. Numerous publicly listed companies have seen their share price drop amid accusations that the controlling shareholders manipulated the relationship between listed and privately held subsidiaries. Admittedly, we can look only at the second-order effect of how much institutional investors are willing to pay for better governance. Yet a 22 percent premium for Asian equities is significantly higher than the 13 or 14 percent that these stocks enjoy in the United States and Europe. Poor governance contributes to market inefficiencies, which in turn lead to volatile markets that have to make larger corrections periodically in order to adjust for gaps in information and in perception.

Volatility and risk. Asia has been volatile. Volatility alone would not result in lower valuations, but the higher betas associated with it increase the cost of capital for Asian companies. Compared with US and European equity markets, volatility in Asian markets has been more pronounced over the past ten years. The lone exception has been Japan, which didn't create any value over this period either (Exhibit 4).

Together, these aggregate analyses illuminate the challenge outsiders face as they seek to invest in Asia. While both Asian and multinational companies have been extremely successful in these markets, the number of poorly managed performers is far greater than the number of successes.

In Asia, the outlook is favorable for companies looking to build long-term value and improve manufacturing efficiencies. But Asian markets may not be the easy answer for companies attempting to boost their short-term growth. Those investing in Asia should take a careful look at what really affects returns to public shareholders.