The Baltic states: throwing off a history of conflict and communism

published 29 June 2018

902_MW_P28_Analysis — The Latvian capital of Riga is the largest city in the Baltic states

The Baltic economies are too small to attract the attention of many investors but it's worth keeping an eye on dynamic entrepreneurial markets like these, says Frdric Guirinec.

Located on the eastern fringes of Europe, the Baltic states of Estonia, Latvia and Lithuania seem geographically isolated from the main body of the European continent. However, control of this territory has been frequently and fiercely disputed throughout European history. In the 12th and 13th centuries, the Baltic territorities were conquered by the crusading Teutonic knights. They were twice annexed by the great power to their east: first by Russia under Catherine II and later by the Soviet Union under Stalin. Throughout most of their history they followed different destinies under the influence of the Swedish and Danish kingdoms or the Polish-Lithuanian Commonwealth. The empire of the latter stretched from the Baltic Sea to the shores of the Black Sea and thereafter to the Ottoman Empire's borders, making it one of the largest territories in Europe before it went into decline in the 18th century and saw territory partitioned between Prussia, Russia and Austria's Habsburg Empire.

Consequently, the Baltic region has been the meeting point of many influences, mainly Nordic, Teutonic and Russian, and was the crossroads of many trades. They were part of the Hanseatic League the trade and defensive confederation of cities and towns that governed maritime trade along the coast of northern Europe in the Middle Ages. However, the three Baltic republics that we know today never existed as truly independent states, except for a brief period between the two world wars. At that time, the three Baltic countries (and Finland) were considered strategic as they provided a buffer ("cordon sanitaire" in the term of the time) against revolutionary Russia and prevented it from accessing the Baltic Sea until they were subsumed by the Soviet Union during World War II.

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Then in 1991 the secession of the Baltics from the Soviet Union reestablished them as independent states and created the precedent for other parts of the union to depart, contributing to its dissolution. Today, the Baltic States are open and agile economies. They have been part of the European Union since 2004 and adopted the euro between 2011 and 2015. They offer some of the lowest taxation levels in Europe, with Estonia being the first state to introduce the flat tax, and high incentives for entrepreneurship.

These are relatively small economies. The Visegrad group which includes Poland, Czech Republic, Hungary and Slovakia has a combined GDP of close to $2trn in purchasing power parity terms (PPP, which accounts for the difference in the price of goods and services between countries), equal to around 70% of the UK economy. The Baltic states together have a GDP of only around $185bn in PPP terms, and a total population of around six million. However, GDP per capita is around $31,000 for Estonia and Lithuania, putting them above long-term EU members Portugal or Greece (Latvia is lower at around $27,000, which is in line with Greece and significantly more than new EU entrants such as Bulgaria and Romania).

Small but dynamic and open, the Baltic states have a great deal in common. In particular, they are notably entrepreneurial, especially in technology and financial technology. Communications service Skype (created by Swedes and Estonians) and money-transfer service TransferWise are the most popular companies in Europe in their fields. Given the lack of large companies investing heavily in research and development, the Baltic states have instead bolstered the ease of company creation with the goal of attracting start-ups, and rank in the top 20 in terms of ease of doing business according to the World Bank, alongside their neighbouring countries of Sweden, Finland, Denmark.

The World Economic Forum ranked the three Baltic states in the top seven, along with Sweden, of the most innovative in the EU. This takes into account both the activity of creating start-ups and creativity of employees in existing enterprises. Entrepreneurship is favoured by a friendly tax system. For example, Latvia elaborated a special visa programme for start-ups, which provides tax relief for professionals in the technology sector. Last year, the three states announced plans to create a common capital market to combine their strengths and attract greater levels of foreign direct investments, which at present is perhaps constrained by each individual country's relatively small size.

Nevertheless, historical and cultural differences between the three countries mean their economies also have different characteristics. For example, the Estonian economy is particularly highly integrated with its Scandinavian neighbours. Finland and Sweden have had positive influences on Estonian economic development, especially in the technological and telecommunication sectors. Estonia has developed a business-friendly environment. The World Economic Forum ranked Estonia 32nd in terms of competitiveness, ahead of the fast-growing Czech Republic.

Lithuania represents half of the Baltic economy with a GDP of $90bn (PPP) and is ranked 41st by the World Economic Forum, in line with Poland. The Lithuanian economy was affected by the Western sanctions on Russia (its largest trading partner) and the Russian response to these: Lithuanian agriculture exports to Russia were abruptly stopped. However, Lithuania also has well-established cultural and business ties to Europe. The country's stable political environment, a supportive economic environment and highly skilled and qualified population have attracted foreign investment. For example, banking group Barclays opened a technical-support centre in Vilnius, employing 1,100 professionals supporting retail operations globally, while payments provider Western Union created its European regional operations centre in the city. Lithuania has also an important chemical sector, and a nascent biotech and pharmaceutical research sector.

Latvia is a hub connecting the Baltic states, providing a main transport route connecting Russia to Europe through the ports of Riga, Liepaja and Ventspils, as well as a gateway to Nordic countries. The new Rail Baltica will facilitate even more trade flows. This €6bn railway corridor, which is supposed to begin construction in 2019, is intended to connect Nordic countries to Central Europe from Helsinki to Berlin, passing Warsaw. Riga itself is the largest city in the Baltic states with a population of one million inhabitants including suburbs, making it only slightly smaller than Stockholm. It has also become the financial hub of the Baltic region and is home to an established pharmaceutical industry.

Shares in emerging Europe are generally attractively valued, on an average cyclically adjusted price/earnings (Cape) ratio of around nine, half of Europe, a third of the US. However, even fewer foreign investors venture into the Baltic markets than into the rest of emerging Europe, largely because the local stockmarkets are very small. In total, there are around 70 listed companies. The exchanges are owned by Nasdaq, the US exchange operator, and are pooled together as Nasdaq Baltic, but the companies are still listed on their home market and supervised by the local financial authority.

However, one UK-regulated discount stockbroker US-based Interactive Brokers has offered access to the Baltic exchanges with effect from earlier this year, meaning that they are readily accessible to adventurous private investors. And there are a handful of interesting companies, ignored by large portfolio managers due to their small size and lack of liquidity, that may be worthy of further investigation.

For example, the Latvian firm Madara Cosmetics (Riga: MDARA) was listed last year. The company, which produces organic skincare products, generated €7.5m turnover and earnings before interest, tax, depreciation and amortisation (Ebitda) of 24%, with strong liquidity ratios. The price/earnings (p/e) ratio of 17.5 is not high, given valuations in the sector, and reflects its strong potential for growth.

Auga Group (Vilnius: AUG1L) is an organic food producer in Lithuania, which claims to offer full traceability from the field to the shelf. It farms 33,000 hectares and milks 3,500 cows, exporting much of its output to Scandinavia, western Europe and Japan. The company generated close to €50m of sales in 2017, with a 13.4% operating margin, and trades on a p/e ratio of 16.5. Dairy producer Zemaitijos Pienas (Vilnius: ZMP1L) generated record sales of €171m in 2017, of which 70% were realised in the Baltic region. Profitability tends to be cyclical and recently its Ebitda margin disappointed, declining to 6%, and it trades on a p/e of 15.5. It has low leverage and may be worth monitoring for a turnaround.

There are also a handful of real-xestate plays, such as Pro Kapital Grupp (Tallinn: PKG1T) and INVL Baltic Real Estate (Vilnius: INR1L), which offer exposure to local property markets. If the Baltic states' entrepreneurial culture translates into rising wealth, real-estate prices might benefit. Unfortunately, none of the region's technology start-ups have yet made it to a local listing Skype, for example, was bought by Microsoft. Hopefully one of the new crop might buck that trend.

Frederic is an investment analyst. He started his career at JP Morgan in Paris. He has more than ten years of experience investing in private equity and also worked with the 3i debt management team investing in private debt. He is an ACCA member and a CFA charterholder. He graduated from Edhec Business School.