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U N I V E R S I T Y

OF

T E

A S

John Connell | Angela Morisette | Parker Kim

Company Overview

1
FNMA buys mortgages on the secondary market

FNMA pools mortgages into packaged securities

FNMA sells mortgagedbacked securities to investors

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Company Overview

FNMA is a critical component to the United States ability to lead the 1 2 rates providing stability, credibility, 3 world in homeownership FNMA pools FNMAand sells FNMA buys liquidity to the mortgage mortgages into market mortgagedmortgages on the secondary market packaged securities backed securities to investors

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Investment Thesis
Shareholders are suing the US Treasury over unlawful seizure of private assets

This seizure of shareholder assets is a violation of the Takings Clause of the 5th Amendment

Should the court rule in favor of shareholders, we believe substantial value to be unlocked

FNMA presents an astounding 10-15x in upside potential

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Conclusion

FNMA Timeline
Government spends $188bn to bail out FNMA in exchange for senior preferred stock offering a 10% dividend Federal Housing Finance Agency (FHFA) puts FNMA under conservatorship Shareholders file lawsuits against the US Government alleging the Treasury acted illegally when it amended the terms of FNMAs deal with the government

2008:

Financial Crisis

2012: Government amends agreement

Current: Ongoing litigation

Future: shareholders win/lose

FNMA unexpectedly returns to profitability US Government forgoes previous dividend policy and lays claim to all FNMA profits effectively shutting off equity holders from future earnings

There are two possible outcomes for FNMAs shareholders as value is derived from future legislation, not FNMAs core business

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Possible Outcomes for Stakeholders


Outcome of Litigation Share Price Reaction
Share price drops to zero

Shareholders lose

Shareholders win

Share price growth opportunities upwards of 10-15x market value

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itigation

Key Issue
Under 2012 Amended Agreement Under 2008 SPS Agreement

Senior Preferred Stock

CF to Government (Fixed Amount- 10%)

FNMA Profits

Preferred and Common Stock

CF to Private Investors (Residual)

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Key Issue
Under 2012 Amended Agreement Under 2008 SPS Agreement

CF CF to to Government Government Preferred (Fixed AllAmountProfits 10%) Stockof private profits violate Does the US Treasury and FHFAs seizure Senior th Amendment FNMA Profits Preferred the Takings Clause of the 5 Stock by amending the terms of its stock to eliminate
Preferred and Common Stock

Key Issue: Senior

all private shareholders?


CF to Private Investors (Residual)

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Litigation Overview
Perry Capital v. Treasury & FHFA

The Treasurys 2012 amendment to the SPS agreement is illegal under the Takings Clause of the 5th Amendment and is an abuse of power as a conservator

As FNMA is a GSE and the FHFA is its appointed conservator, FHFA has unrestricted control over the company to impose any changes to the SPS agreement

Argument

Support

Conservative interpretation of HERA governing FHFA Precedent court case Expert opinion

Very liberal interpretation of HERA and FDIA

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HERA and FDIA Language


The Conservators duty is to operate, rehabilitate, reorganize, and restore the health of the troubled institution. When that is achieved, the conservatorship is terminated, and the institution is returned to the private sector. 1145, HERA (2008)

FHFA & Treasury Argument: Like 11 of the FDIA, 1145 of HERA says the conservator has a higher power than any and all stakeholders in the business This sounds like property rights of stakeholders are wiped out under conservatorship; however

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HERA and FDIA Language


The Conservators duty is to operate, rehabilitate, reorganize, and restore the health of the troubled institution. When that is achieved, the conservatorship is terminated, and the institution is returned to the private sector. 1145, HERA (2008)

FHFA & Treasury Rebuttal: Argument: Like 11 of the FDIA, 1145 of HERA stakeholders retain the conservator their says right to payment or has a higher power than any settlement of their claims all stakeholders in onand the business the business This sounds like property rights of It shall, to the extent of proceeds realized stakeholders wiped or sale of from performanceare of contracts under assets ofout the institution, pay all valid obligations of the regulated entity at the time conservatorship; that are due and payable at the time. however

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HERA and FDIA Language


The Conservators duty is to operate, rehabilitate, reorganize, and restore the health of the troubled institution. When that is achieved, the conservatorship is terminated, and the institution is returned to the private sector. 1145, HERA (2008)

HERA and FDIA language supports

Perry Capitals claim that

the Senior Preferred Stock Agreement amendment FHFA & Treasury Rebuttal: Argument: was not within FHFAs as an appointed conservator . Likepower 11 of the This sounds like FDIA, 1145 of HERA property rights of It shall, to the extent of proceeds realized stakeholders retain the conservator stakeholders wiped or sale of from performanceare of contracts their says right to payment or has a higher power than any under assets ofout the institution, pay all valid settlement of their claims obligations of the regulated entity at the time all stakeholders in conservatorship; onand the business that are due and payable at the time. the business however

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Precedent Case
OMelveney & Myers v. FDIC (1994)
American Diversified Savings Bank (ADSB) shareholders in conflict with conservator The FDIC believes its fiduciary duty is to taxpayers, not to ADSB shareholders Supreme Court rules 9-0 in favor of shareholders

The OMelveney & Myers v. FDIC case serves as an effective precedent that tells us courts will issue a ruling in favor of FNMA shareholders

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Expert Opinions

Richard Epstein-- Professor in Constitutional Law, NYU

[language] in the FDIA and the FDIC has shown precedent in following procedures to maximize value for shareholders.

Randall Guynn-- Partner and Head of Financial Institutions Group, Davis, Polk & Wardwell

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Takings law asserts- as its currently construedif the qualitative value of FNMA being wound down is being used as a reason for winding it downyou still need to provide just compensation for existing stakeholders.

Expert Opinions

Richard Epstein-- Professor in Constitutional Law, NYU Randall Guynn-- Partner and Head of Financial Institutions Group, Davis, Polk & Wardwell
Investment Overview Litigation Valuation Considerations Conclusion

there is disclosure regarding and Freddie Expert sentiment isIf overwhelmingly in favor of future FNMA Fannie shareholders: earnings and the administration has a commitment that existing Fannie and Freddie equity holders will never Additionally, experts agree that FNMA has a case common on both a constitutional receive any future positive earningsthis commitment would Takings law asserts- as its currently construedif the be material to investors and should be disclosed. qualitative value of FNMA wound down basis. is being used as a andbeing contractual reason for winding it downyou still need to provide just Lewis Lowenfels-Managing Partner, Tolins & Lowenfels compensation for existing [language] in the stakeholders. FDIA and the FDIC has shown precedent in following procedures to maximize value for shareholders.

aluation

Decision Tree
Litigation Outcome Payoff Market-Defined Probability

Favorable

PT: $40

9.3%

Unfavorable

$0

90.9%

Due to its investor sentiment surrounding FNMAs past and the risk appetite of investors leaving FNMA, current prices do not accurately reflect the expected value for the litigation payouts.

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Relative Valuation

Peer Analysis Apartment and Investment Management Trust Equity Residential UDR Inc American Capital Agency Corp Anworth Mortgage Asset Corporation Annaly Capital Management Capstead Mortgage Corporation MFA Financial, Inc. Median FNMA AIV EQR UDR AGNC ANH NLY CMO MFA P/E 21.7x 10.0x 16.3x 6.8x 10.6x 3.0x 13.8x 10.0x 10.3x .65x P/B 4.9x 2.0x 2.3x 0.9x 0.9x 0.9x 1.0x 0.9x 1.0x NA

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Relative Valuation
Valuation 2013A EPS (Billions) -DTA Valuation Reclamation 2013A Adj. EPS Industry P/E Peer Group Position Adjustment FNMA P/E Target Expected Market Cap FDSO (Treasury Warrants Exercised) Expected Share Price 84.0 50.6 33.4 10.3x -33% 6.9x 231.2 5.8 $40.12
2.9x 3.9x 4.9x 5.9x 6.9x 7.9x 8.9x 9.9x 10.9x $16.81 $22.61 $28.41 $34.20 $40.00 $45.80 $51.59 $57.39 $63.19 348% 503% 657% 812% 967% 1121% 1276% 1430% 1585%

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Historical Financial Information

12.0x

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Historical Financial Information

12.0x

Significant downward pressure on valuations

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Historical Financial Information

12.0x

Significant downward pressure on valuations Valuations remain depressed despite a major upturn in profitability

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onsiderations

Investment Execution
FNMA Rest of Portfolio

Portfolio Return: +15%

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Investment Execution
FNMA Rest of Portfolio
Catalyst

Portfolio Return: Portfolio +15% Return: -1%

Due to its rare

risk-return profile, FNMAs payoffs can result in immaterial losses, but its upside potential contributes significantly to overall portfolio return if sized correctly.
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Catalysts

OMelveny & Myers v. FDIC (1994)

1 2 3

October 1993- Case Filed


March 1994- Went to Court July 1994- First Decision October 1995- Supreme Court Decision

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onclusion

Investment Thesis
Shareholders are suing the US Treasury over unlawful seizure of private assets

This seizure of shareholder assets is a violation of the Takings Clause of the 5th Amendment

Should the court rule in favor of shareholders, we believe substantial value to be unlocked

FNMA presents an astounding 10-15x in upside potential

Investment Overview

Litigation

Valuation

Considerations

Conclusion

uestions

Appendix Slides
Government Plans for FNMA- 23 Intrinsic Valuation- 24 Legislation Current Progress- 25 Capital Structure- 26 Risks- 27 Price Chart- One Year- 28 Management- 29 Circumstances Surrounding Entering Conservatorship- 30 Capital Structure Breakdown over time- 31 Shareholder Base- 32 Senior Preferred Stock Agreement- 33 Historical Interest Income- 34 FDSO Calculation- 35 DCF Flaws- 36 Calculating Discount to P/E- 37 Addressing the GSE- Ultimate Power- 38 Theodore Olson Strong Attorney- 39 OMelveny and Myers v. FDIC 1994- 40 Existing FNMA Structure- 41 Government Suggested Structure- 42 Price Chart- Since 2007- 43 Why is it Mispriced?- 44 Recent News Decision Trees-45 Housing Industry in Regards to FNMA- 46 Credit Quality- 47 Twitter Sentiment Analysis- 48

Litigation- 6 Valuation- 12 Conclusion- 19

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Government Plans for FNMA


1
Only if the government wipes out shareholders through legislation means will it be able to shut down FNMA

A new system would feature several smaller versions of FNMA in which the government would financially back mortgagesnot firms.

The governments plans for FNMA do not impact FNMAs value unless the government is able to wipe out private investors.

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Intrinsic Valuation
Analyst Case 2008A 42877 34341 8536 19.9% 1032 947 0 6557 15.3% 2597 3960 2009A 40813 28204 12609 30.9% 1133 1074 0 10402 25.5% 4119 6283 Historical 2010A 2011A 154616 143449 141035 13581 8.8% 1277 1320 0 10984 7.1% 4350 6634 133636 9813 6.8% 1236 1134 0 7443 5.2% 2947 4496 2012A 129677 110193 19484 15.0% 1195 1172 238 16879 13.0% 6684 10195 2013A 118740 92355 26385 22.2% 1218 1327 1001 22839 19.2% 9044 13795 2014E 116615 93292 23323 20.0% 1633 1866 1633 18192 15.6% 7204 10988 0.87 9519 18,963 6.0x 49,672 5,762 $8.62 2015E 114877 91902 22975 20.0% 1551 1723 1493 18208 15.9% 7210 10998 0.68 7501 Projected 2016E 110305 88244 22061 20.0% 1434 1544 1324 17759 16.1% 7033 10726 0.54 5759 2017E 106996 85597 21399 20.0% 1391 1391 1177 17440 16.3% 6906 10534 0.42 4453 2018E 104856 83885 20971 20.0% 1258 1258 1153 17301 16.5% 6851 10450 0.33 3478 Interest and Dividend Income Interest Expense, Total Net Interest Income Net Interest Margin Salaries and Other Empl. Benefits Cost of Services Provided Other Operating Exp. Operating Income Operating Margin Tax Expense EFCF Discount Factor PVEFCF Terminal Value Exit Multiple (P/E) Equity Value FDSO Share Value

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Legislation Current Progress


Right now, Perry Capital LLC v. Department of Treasury is in pre-court phase
P files lawsuit against D in July 2013 D issues rebuttal in November 2013 A federal judge grants P a motion to conduct discovery in February 2014

Pre-Court, 8 months

Lower Court Appeal

State Court Appeal

Supreme Court

P WINS D WINS

Court, 1.5 years

Post-Court

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Capital Structure
A
117.1bn
Senior Preferred StockHeld by US Treasury, initially issued to provide a bailout during 2008. Initially Issued with a 10% dividend paid quarterly on the liquidation preference, with unpaid dividends accruing to the LP. Amended in 2012 to pay out all of net worth.

B
19.1bn

E-Shares Preferred Equity2.25% dividend payment on liquidation preference. Non-cumulative dividend, perpetual maturity. Entitled to full dividend satisfaction before funds can be passed on to common equity holders. Common EquityUS Treasury currently holds warrants to purchase up to 79.9% of outstanding common stock that have not yet been exercised. Under the existing senior preferred stock agreement, no new common equity may be issued.

C
24.1bn

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Risks
OMelveney & Myers v. FDIC Gave a related decision that the FDICs role as a conservator was to maximize firm value There is no precedent that dictates FHFA cannot abuse its conservator powers to eliminate equity holders

The core business will struggle if the overall housing market deteriorates- eroding FNMAs significant upside potential

FNMAs stock price currently reflects concerns over distributable cash flows, not the fundamentals of the core business

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Price Chart- One Year

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Management
Timothy J. Mayopoulos, President and CEO
CEO since June 2012, joined FNMA in 2009 serving as General Counsel and EVP 25 Years of legal Experience in BAML, CSFB, DB, and DLJ, DPW $600K Base and Total Salary

David C. Benson, 54, Executive VP and CFO since April 2013


Served in FNMA/FMCC for 12 years in various executive roles Previously an MD for Merrill Lynch $574k Base Salary, $1.4M Deferred Salary

Terrence W. Edwards, 58, Executive VP and COO since Sept. 2013


Joined FNMA in Sept. 2009 in Credit Portfolio Management Previously CEO of PHH Corporation, a mortgage and fleet management services company and CEO of Cendant Mortgage Company $500K Base Salary, $1.2M Deferred Salary

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Circumstances Surrounding Entering


Boards of Fannie and Freddie consented to being put into conservatorship because that would insulate the boards from liability At the time, the board consented to entering conservatorship on a number of agreements- one of which was that it would remain publicly held so it could emerge from conservatorship as a private company with normal corporate governance structure. Had the board not consented to entering conservatorship, FHFA did NOT have the statutory authority to force the company in. So turning back on this is highly illegal
FHFA now says they have a responsibility to taxpayers to destroy it but! HERA and FDIA and Precedent court cases tell us as a conservator, you owe shareholders more than taxpayers

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Cap Structure Breakdown over Time

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Shareholder Base
Existing Shareholders Pershing Square Capital Mgmt. Fairholme Capital Mgmt. Capital Research & Mgmt. Co. Seamans Capital Mgmt. 13D Mgmt. Buying Shareholders Pershing Square Capital Mgmt. Fairholme Capital Mgmt. Seamans Capital Mgmt. 13D Mgmt. Jet Capital Investors Selling Shareholders MetLife Advisers, LLC Lord, Abbett & Co. New Shares -.2m -.1m Ownership 0.01% 0.06% New Shares +115.6m +25.9m +2.2m +.6m +.4m Ownership 9.98% 2.24% 0.19% 0.05% 0.03% Shares 115.6m 25.9m 12.5m 2.2m .6m Ownership 9.98% 2.24% 1.08% 0.19% 0.05%

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Senior Preferred Stock Agreement


Issued as an initial commitment fee in consideration of the commitment from the treasury to provide funds. On a quarterly basis, they can draw funds up to the amount, if any, by which their liabilities exceed total assets. The stock started at 1.0bn liquidation value, but has had mispayments of dividends accrue to a total liquidation value of 117.1bn Used to be 10% dividend but this has changed to an amount based on net worth (total assets total liabilities) capital reserve (2.4bn 600m each year until zero on Jan 1 2018) <- effectively no CF to other ivnestors, this is whats being lawsuited (2012 amendment to the agreement) They can pay common stock dividends after the senior pref is paid in full with all liquidation pref and dividends Funding commitment must be terminated in order to fully buyout the treasury

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Historical Interest Income


Income Statement For the Fiscal Period Ending Currency Interest and Div. Income, Total Interest Expense, Total Net Interest Income %Margin Restated 12 months Dec-31-2003 USD 47,833.0 29,587.0 18,246.0 38.1% 12 months Dec-31-2004 USD 47,456.0 29,737.0 17,719.0 37.3% Reclassified 12 months Dec-31-2005 USD 44,756.0 33,339.0 11,417.0 25.5% Reclassified 12 months Dec-31-2006 USD 42,936.0 36,875.0 6,061.0 14.1% Reclassified 12 months Dec-31-2007 USD 44,713.0 40,185.0 4,528.0 10.1%

Reclassified 12 months Dec-31-2008 USD 42,877.0 34,341.0 8,536.0 19.9%

Reclassified 12 months Dec-31-2009 USD 40,813.0 28,204.0 12,609.0 30.9%

Reclassified 12 months Dec-31-2010 USD 154,616.0 141,035.0 13,581.0 8.8%

12 months Dec-31-2011 USD 143,449.0 133,636.0 9,813.0 6.8%

Reclassified 12 months Dec-31-2012 USD 129,677.0 110,193.0 19,484.0 15.0%

12 months Dec-31-2013 USD 118,740.0 92,355.0 26,385.0 22.2%

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FDSO Calculation

FDSO Current Shares Outstanding(1) Treasury Warrant Ownership FDSO 1,158.1 79.90% 5761.592

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DCF Flaws
We do not believe there is a material variant perspective when pricing the fundamentals of a $300bn secondary mortgage financing giant Consequently, we believe analyst estimates serve as our best insight into the value of FNMA under normal capital payout structures Additionally, applying a single WACC for FNMA is inappropriate, as the risk of FNMA is tied to its capital structure-related cash flow considerations, not the core fundamentals of the business.

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Calculating Discount to P/E


For the Fiscal Period Ending Currency Interest and Div. Income, Total Interest Expense, Total Net Interest Incom e %Margin Restated 12 m onths Dec-31-2003 USD 47,833.0 29,587.0 18,246.0 38.1% 12 m onths Dec-31-2004 USD 47,456.0 29,737.0 17,719.0 37.3% Reclassified 12 m onths Dec-31-2005 USD 44,756.0 33,339.0 11,417.0 25.5% Reclassified 12 m onths Dec-31-2006 USD 42,936.0 36,875.0 6,061.0 14.1%

Normalized Profitability Potential

Average = 28.8% Average (ex-2006) = 33.7% Median = 31.4% 2013 Margin = 22.2% Avg Margin = 33.7% 22.7/33.7 = 33% Discount

Assuming capped profitability

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Addressing the GSE-Ultimate Power


Why we think being a GSE doesnt necessarily give it ultimate power

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Theodore Olson Strong Attorney


Appointed to U.S. Solicitor in 2001, served until 2004 when he retired and went back to private practice Olson successfully represented presidential candidate George W. Bush in the Supreme Court case Bush v. Gore, which effectively ended the recount of the contested 2000 Presidential election. 2006 landmark case, defended journalists in Supreme Court case to defend their rights to keep sources confidential, even as request of court 2011 - awarded the ABA Medal, the highest award of the American Bar Association Won federal lawsuit for plaintiff in Perry v. Schwarzenegger, which challenged Proposition 8, a California state constitutional amendment banning same-sex marriage Named one of Times Top 100 Thinkers for his work on this case
The governments scheme to wipe out these investors is bad policy and a plain violation of the law that respects private, investment-backed expectations and our constitutional protection of property rights.

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OMelveny and Myers v. FDIC 1994

FDIC tried to show it had power beyond what the FDIA allowed for it in conservatorship, but the supreme court said under the statute, when you become a conservator, you step into the shoes as a stakeholder and have a duty to maximize value for the stakeholders.

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Existing Structure

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Government Suggested Structure

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Price Chart- Since 2007

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Why is it mispriced?
Overly Negative Investor Sentiment
Few people want to be involved with a company that was at the headlines of 2008s housing meltdown 2008 overshadows the litigation thesis

Unique Risk Appetite Required


Few investors are willing to invest in something where a 100% loss is possible, ignoring the significant upside.

Litigation Analysis
Our precedent case is not a direct reference to the FHFA-HERA case, as it relates to FDIC-FDIA but given how FHFA-HERA are modeled after FDICFDIA we believe it is a perfect precedent case nonetheless.

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Recent News Decision Tree


Litigation Outcome Post-Litigation Outcome Probability/Payout FNMA is able to pay out profits

80% / $40
FNMA continues on with the SPS dividend = NI

Today

10% / $0

FNMA is wound down according to Johnston-Crapo

10% / $0

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Housing Industry in Regards to FNMA


As rates rise, lenders will loosen rates and more mortgages will be available on the market
Since 1999, mortgage purchase applications and all measures of sales activity have actually been higher when mortgage rates were higher. Forbes

In 2013, 2.5 million underwater homeowners regained positive equity status thanks to an increase in housing value which strengthens FNMAs existing portfolio
Why? As default risk in FNMAs portfolio decreases, FNMAs investments are more likely to reach maturity

Forecasted market trends do not negatively affect FNMAs business model


Frankly, we see that our retail execution, selling individual homes to individual buyers, as still our best execution strategy. So, we will still continue to do the vast bulk of our executions in that way. FNMA CEO Timothy Mayopoulus (Q4 2013)

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Credit Quality

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Twitter Sentiment Analysis


Average sentiment per tweet mentioning litigation
-21%

-100%
Negative

0%
Neutral

100%
Positive

Simple random sample of top 1400 most influential tweets from March 10th March 18th Classified each tweet in two categories:
Litigation mentioned, yes or no? Sentiment score: 1 positive, 0 neutral, -1 negative

Calculated the net effect of positive and negative tweets as an average sentiment per tweet

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