Author: @Web3_Mario
Summary: Last week, we explored the potential benefits of Lido due to changes in the regulatory environment, hoping to help everyone seize this Buy the rumor trading opportunity. This week, there is an interesting theme regarding the heat around MicroStrategy, with many predecessors commenting on this company's operating model. After digesting and studying it deeply, I have some personal views that I hope to share with you all. I believe the reason for MicroStrategy's stock price increase lies in the 'Davis Double Play,' linking the business design of financing to purchase BTC with the appreciation of BTC to the company's profit, and leveraging funds obtained through innovative designs that combine traditional financial market financing channels, allowing the company to surpass the profit growth brought by the appreciation of its BTC holdings. At the same time, with the expansion of holdings, the company gains some pricing power over BTC, further strengthening this profit growth expectation. However, its risk lies in this: when the BTC market experiences turbulence or reversal risks, the profit growth from BTC will stagnate, and under the pressure of the company's operating expenses and debt, MicroStrategy's financing capability will be significantly reduced, impacting profit growth expectations. Unless there is a new boost to further raise BTC prices, otherwise, the positive premium of MSTR relative to BTC holdings will converge quickly. This process is what is referred to as the 'Davis Double Kill.'
What are the Davis Double Play and Double Kill?
Familiar friends should know that I am committed to helping more non-financial professionals understand these dynamics, hence I will replay my thought logic. Therefore, first, I will supplement some basic knowledge about what 'Davis Double Play' and 'Double Kill' are.
The so-called 'Davis Double Play' was proposed by investment master Clifford Davis, usually used to describe the phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment. These two factors are:
l Company profit growth: The company has achieved strong profit growth, or optimization in business model, management, etc., leading to increased profits.
l Valuation expansion: As the market becomes more optimistic about the company's prospects, investors are willing to pay higher prices, driving up stock valuations. In other words, the company's price-to-earnings ratio (P/E Ratio) and other valuation multiples expand.
The specific logic driving the 'Davis Double Play' is as follows: First, the company's performance exceeds expectations, with both revenue and profits growing. For example, strong product sales, expanded market share, or successful cost control will directly lead to increased profits for the company. This growth will also enhance market confidence in the company's future prospects, leading investors to accept a higher P/E ratio and pay higher prices for the stock, resulting in valuation expansion. This linear and exponential combined positive feedback effect often leads to accelerated stock price increases, known as the 'Davis Double Play.'
To illustrate this process, suppose a company's current P/E ratio is 15 times, and it is expected that its future profits will grow by 30%. If due to the company's profit growth and changes in market sentiment, investors are willing to pay 18 times the P/E ratio, even if the profit growth rate remains unchanged, the increase in valuation will also drive stock prices up significantly. For example:
l Current stock price: $100
l Earnings growth of 30% means that earnings per share (EPS) increase from $5 to $6.5.
l Price-to-earnings ratio increases from 15 to 18.
l New share price: $6.5 × 18 = $117
The stock price rises from $100 to $117, reflecting the dual effect of profit growth and valuation enhancement.
The 'Davis Double Kill' is the opposite, usually used to describe rapid stock price declines under the combined effects of two negative factors. These two negative factors are:
l Company profit decline: The company's profitability declines, possibly due to decreased revenue, rising costs, management errors, etc., leading to profits falling below market expectations.
l Valuation contraction: Due to declining profits or worsening market prospects, investors' confidence in the company's future diminishes, leading to a decline in valuation multiples (such as price-to-earnings ratio) and a drop in stock prices.
The entire logic is as follows: First, the company fails to meet expected profit targets or faces operational difficulties, leading to poor performance and declining profits. This will further worsen market expectations for its future, causing investors to lack confidence and unwilling to accept the currently overvalued price-to-earnings ratio, only willing to pay a lower price for stocks, resulting in a decline in valuation multiples and further decline in stock prices.
Similarly, to illustrate this process, suppose a company's current P/E ratio is 15 times, and it is expected that its future profits will decline by 20%. Due to declining profits, the market begins to have doubts about the company's prospects, and investors start to lower its P/E ratio. For example, reducing the P/E ratio from 15 to 12. The stock price may thus drop significantly, for example:
l Current stock price: $100
l Earnings decline by 20%, meaning earnings per share (EPS) drop from $5 to $4.
l P/E ratio drops from 15 to 12.
l New share price: $4 × 12 = $48
The stock price falls from $100 to $48, reflecting the dual effect of profit decline and valuation contraction.
This resonance effect usually occurs in high-growth stocks, especially in many technology stocks, as investors are generally willing to pay a higher premium for the future growth of these companies. However, such expectations often have considerable subjective support, so the corresponding volatility is also large.
How MSTR's high premium is created and why it becomes the core of its business model.
After supplementing this background knowledge, I believe everyone should have a general understanding of how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy switched its business from traditional software services to financing for purchasing BTC, and does not exclude future revenue from asset management. This means that the company's profits come from capital gains from BTC appreciation acquired through equity dilution and debt issuance. With the appreciation of BTC, all investors' shareholder equity will correspondingly increase, benefiting investors; in this regard, MSTR is no different from other BTC ETFs.
The distinction arises from the leverage effect brought by its financing capability, as MSTR investors' expectations for future profit growth are derived from leverage gains obtained through its financing capability. Considering that MSTR's total market value relative to its total BTC holdings is in a positive premium state, it means that MSTR's total market value is higher than the total value of its BTC holdings. As long as it remains in this positive premium state, regardless of equity financing and convertible bond financing, accompanied by the funds obtained to purchase BTC, it will further increase earnings per share. This gives MSTR the ability to achieve profit growth different from that of BTC ETFs.
For example, suppose MSTR currently holds $40 billion in BTC, total circulating shares X, and its total market value Y. Then, the earnings per share will be $40 billion / X. Assuming the worst-case scenario of equity dilution for financing, if the proportion of new shares issued is a, it means total circulating shares become X * (a + 1), resulting in total financing of a * Y billion dollars at current valuations. If all these funds are converted into BTC, the BTC holdings will increase to $40 billion + a * Y billion, meaning earnings per share will become:
We will calculate the dilution effect on earnings per share by subtracting it from the original earnings per share, as follows:
This means that when Y exceeds $40 billion, which is the value of its BTC holdings, it indicates the existence of a positive premium. Completing financing to purchase BTC will bring earnings per share growth greater than 0, and the greater the positive premium, the higher the earnings per share growth. The two have a linear relationship, while the impact of dilution proportion a shows an inverse relationship in the first quadrant, indicating that the fewer new shares issued, the greater the increase in equity.
Therefore, for Michael Saylor, the positive premium of MSTR's market value relative to the value of the BTC he holds is the core factor for his business model to be established. Thus, his optimal choice is how to maintain this premium while continuously raising funds, increasing his market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will also enhance investors' confidence in future growth even at high price-to-earnings ratios, allowing him to complete fundraising.
To summarize, the secret of MicroStrategy's business model lies in the appreciation of BTC driving the company's profit increase, and a favorable trend in BTC growth indicates a positive trend in business profit growth. With the support of this 'Davis Double Play', the positive premium of MSTR begins to amplify, so the market is betting on how high MicroStrategy can be valued with a positive premium for subsequent financing.
What risks does MicroStrategy bring to the industry?
Next, let's talk about the risks that MicroStrategy brings to the industry. I believe its core lies in that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of volatility. The reason lies in the 'Davis Double Kill', and the period when BTC enters a high-level turbulence phase is the beginning of the entire domino effect.
Let's imagine that when the growth of BTC slows down and enters a turbulence phase, MicroStrategy's earnings will inevitably start to decline. Here, I want to elaborate on this, as I see some friends placing great importance on their holding costs and unrealized gains. This is meaningless because, in MicroStrategy's business model, profits are transparent and equivalent to real-time settlement. In the traditional stock market, we know that the factors causing stock price fluctuations are earnings reports; only when quarterly earnings reports are published will the true profit levels be confirmed by the market. In the meantime, investors only estimate changes in financial conditions based on external information. In other words, for most of the time, stock price reactions lag behind the company's real earnings changes. This lagging relationship will be corrected when each quarterly earnings report is released. However, in MicroStrategy's business model, both its holding scale and the price of BTC are public information. Therefore, investors can understand its real profit level in real-time, and there is no lag effect because earnings per share change dynamically, equivalent to real-time profit settlement. Given this, stock prices already reflect all profits accurately, with no lag effect, making it meaningless to focus on holding costs.
Bringing the topic back, let's see how the 'Davis Double Kill' unfolds. When BTC's growth slows down and enters a phase of turbulence, MicroStrategy's earnings will continuously decline, even to zero. At this time, the fixed operating costs and financing costs will further shrink the company's earnings, possibly even leading to a loss. During this turbulence, market confidence in the future development of BTC prices will continuously erode. This will translate into questioning MicroStrategy's financing ability, further impacting expectations for its profit growth. Under the resonance of these two factors, MSTR's positive premium will quickly converge. In order to maintain the validity of its business model, Michael Saylor must maintain the state of positive premium. Therefore, selling BTC to regain funds for stock repurchase is a necessary operation, and this is the moment MicroStrategy begins to sell its first BTC.
Some friends may ask, why not just hold BTC and let the stock price naturally fall? My answer is no, more precisely, when the BTC price reverses, it is not possible; during turbulence, it can be tolerated to some extent, due to MicroStrategy's current equity structure and what constitutes the optimal solution for Michael Saylor.
Based on the current shareholding ratio of MicroStrategy, there are several top-tier consortiums involved, such as Jane Street and BlackRock, while Michael Saylor, as the founder, holds less than 10%. However, through the design of dual-class shares, Michael Saylor has absolute voting power since he holds more B-class common stock, and the voting rights of B-class common stock are 10:1 compared to A-class. Therefore, this company is still under Michael Saylor's strong control, but his equity stake is not high.
This means that for Michael Saylor, the company's long-term value is far greater than the value of the BTC he holds, because if the company faces bankruptcy liquidation, he will not obtain much BTC.
So what are the benefits of selling BTC during a turbulent phase and repurchasing shares to maintain the premium? The answer is obvious. When a premium convergence occurs, if Michael Saylor judges that MSTR's price-to-earnings ratio is undervalued due to panic, then selling BTC to regain funds and repurchasing MSTR from the market is a profitable operation. Therefore, the repurchase at this time will amplify the effect of reducing circulation on the earnings per share, more than the effect of reducing BTC reserves on decreasing earnings per share. After the panic subsides and the stock price recovers, earnings per share will become higher, benefiting future development. This effect is easier to understand in extreme cases of BTC trend reversal, when MSTR exhibits a negative premium.
Considering Michael Saylor's current holdings, and during turbulent or downturn periods, liquidity is usually tightened. Therefore, when he starts to sell, the price of BTC will decline, accelerating the drop. This acceleration will further worsen investors' expectations of MicroStrategy's earnings growth, leading to a lower premium rate, which may force him to sell BTC to repurchase MSTR. At this point, the 'Davis Double Kill' begins.
Of course, there is another reason that forces it to sell BTC to maintain its stock price, which is that the investors behind it are a group of all-powerful Deep State actors who cannot passively watch the stock price drop to zero, and they must put pressure on Michael Saylor to force him to take responsibility for managing his market value. Moreover, I found recent information indicating that with ongoing equity dilution, Michael Saylor's voting rights have already fallen below 50%, although I have not found a specific source for this news. But this trend seems inevitable.
Does MicroStrategy's convertible bond really have no risk before maturity?
After the above discussion, I believe I have comprehensively articulated my logic. I also hope to discuss a topic: Does MicroStrategy not have debt risk in the short term? Some predecessors have introduced the nature of MicroStrategy's convertible bonds, and I will not elaborate on that here. Indeed, the duration of its debt is quite long. Before the maturity date arrives, there is indeed no repayment risk. However, my view is that its debt risk may still be reflected in stock prices in advance.
The convertible bonds issued by MicroStrategy essentially combine a bond with a free call option. Upon maturity, creditors can request MicroStrategy to redeem based on the previously agreed conversion rate to the stock's equivalent value. However, there is also protection for MicroStrategy, as it can actively choose the redemption method using cash, stock, or a combination of both, providing some flexibility. If funds are sufficient, they can repay more in cash to avoid dilution of equity; if funds are insufficient, they can offer more stock. Additionally, this convertible bond is unsecured, so the risks associated with debt repayment are not significant. Moreover, there is another protection for MicroStrategy: if the premium rate exceeds 130%, MicroStrategy can also choose to redeem at its original cash value directly, creating conditions for refinancing negotiations.
Thus, the creditor of this debt will only have capital gains when the stock price is above the conversion price and below 130% of the conversion price. Besides, there is only principal plus low interest. Of course, after being reminded by teacher Mindao, the investors in this bond are mainly hedge funds using it for Delta hedging to earn volatility returns. Therefore, I thought carefully about the underlying logic.
Delta hedging through convertible bonds is mainly done by purchasing MSTR convertible bonds while shorting an equal amount of MSTR stock to hedge against risks brought by stock price fluctuations. Moreover, as the subsequent price develops, hedge funds need to continuously adjust positions for dynamic hedging. Dynamic hedging usually has the following two scenarios:
l When MSTR's stock price falls, the Delta value of the convertible bonds decreases because the conversion rights of the bonds become less valuable (closer to 'out-of-the-money'). At this time, it is necessary to short more MSTR shares to match the new Delta value.
l When the MSTR stock price rises, the Delta value of the convertible bonds increases because the conversion rights of the bonds become more valuable (closer to 'in-the-money'). At this point, buying back some of the previously shorted MSTR shares to match the new Delta value helps maintain the hedge of the portfolio.
Dynamic hedging needs to be frequently adjusted under the following circumstances:
l Significant volatility in the underlying stock price: such as drastic changes in Bitcoin prices leading to severe fluctuations in MSTR's stock price.
l Changes in market conditions: Such as volatility, interest rates, or other external factors affecting the pricing model of convertible bonds.
l Typically, hedge funds trigger operations based on the amplitude of Delta changes (for example, every change of 0.01) to maintain precise hedging of the portfolio.
Let's take a specific scenario to illustrate. Suppose a hedge fund's initial positions are as follows.
l Purchase $10 million worth of MSTR convertible bonds (Delta = 0.6).
l Short selling $6 million worth of MSTR stock.
When the stock price rises from $100 to $110, the Delta value of the convertible bond becomes 0.65, thus requiring an adjustment to the stock position.
The calculation requires a buyback of shares to be (0.65−0.6)×$10 million=500,000. The specific operation is to buy back $500,000 worth of stock.
When the stock price falls from $100 to $95, the new Delta value of the convertible bond becomes 0.55, requiring an adjustment to the stock position.
The calculation requires an increase in shorted shares by (0.6−0.55)×$10 million=500,000. The specific operation is short selling $500,000 worth of stock.
This means that when the price of MSTR falls, the hedge funds behind the convertible bonds will short more MSTR shares to dynamically hedge the Delta, further driving down the MSTR stock price, which will negatively impact the positive premium and affect the entire business model. Therefore, risks on the bond side will feedback in advance through stock prices. Of course, during MSTR's upward trend, hedge funds will buy more MSTR, making it a double-edged sword.
