Author: @Web3_Mario
Summary: Last week we discussed the potential benefits that Lido gains from changes in the regulatory environment and hoped to help everyone seize this Buy the Rumor trading opportunity. This week, a very interesting topic is the heat around MicroStrategy. Many predecessors have commented on this company's operational model. After digesting and researching it deeply, I have some personal views to share with you. I believe the reason for the rise in MicroStrategy's stock price lies in the 'Davis Double Play'. Through the business design of financing for purchasing BTC, it binds the appreciation of BTC to company profits and gains financial leverage through innovative designs that combine traditional financial market financing channels, enabling the company to achieve profit growth beyond that brought by the appreciation of its BTC holdings. Meanwhile, as its holdings increase, the company gains a certain pricing power over BTC, further reinforcing this profit growth expectation. However, its risk lies in this: when the BTC market experiences oscillation or reversal risks, profit growth tied to BTC will stagnate, and under the pressure of the company's operating expenses and debt, MicroStrategy's financing ability will be significantly diminished, which will affect profit growth expectations. Unless new support can further elevate BTC prices, the positive premium of MSTR relative to BTC holdings will quickly converge. This process is known as the 'Davis Double Kill.'
What are 'Davis Double Play' and 'Double Kill'
Friends who are familiar with me should know that I am committed to helping more friends without a financial background understand these dynamics, so I will replay my thinking 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, typically used to describe the phenomenon of a company's stock price dramatically rising due to two factors in a favorable economic environment. These two factors are:
Company profits increase: The company has achieved strong profit growth, or optimizations in its business model, management, etc., lead to increased profits.
Valuation expansion: Due to the market's more optimistic view of the company's prospects, investors are willing to pay a higher price for it, driving up the stock's valuation. In other words, the stock'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 increasing. For example, strong product sales, expanding market share, or successful cost control will directly lead to the company's profit growth. This growth will simultaneously enhance market confidence in the company's future prospects, leading investors to accept a higher P/E ratio and pay a higher price for the stock, causing valuations to expand. This combination of linear and exponential positive feedback effects will usually lead to accelerated increases in stock prices, known as the 'Davis Double Play.'
To illustrate this process, suppose a certain company currently has a price-to-earnings ratio of 15, and its future profits are expected to grow by 30%. If, due to the company's profit growth and changes in market sentiment, investors are willing to pay a 18 times P/E ratio, then even if the profit growth rate remains unchanged, the increase in valuation will significantly drive up the stock price, for example:
Current stock price: $100
Profits rise by 30%, meaning earnings per share (EPS) increase from $5 to $6.5.
The price-to-earnings ratio increased from 15 to 18.
New stock price: $ 6.5 × 18 = $ 117
The stock price rises from $100 to $117, reflecting the dual impact of profit growth and valuation increase.
The 'Davis Double Kill' is the opposite, typically used to describe the rapid decline in stock prices due to the combined effects of two negative factors. These two negative factors are:
Company profits decline: The company's profitability declines, possibly due to reduced revenue, rising costs, management errors, and other factors, resulting in profits lower than market expectations.
Valuation contraction: Due to declining profits or deteriorating market outlook, investor confidence in the company's future decreases, leading to a decline in its valuation multiples (such as P/E ratio) and a drop in stock price.
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 make the market's expectations for its future worsen, leading to insufficient investor confidence, and they are unwilling to accept the currently inflated P/E ratio, only willing to pay a lower price for the stock, thus causing a decline in valuation multiples and further drop in stock price.
To illustrate this process, suppose a certain company currently has a price-to-earnings ratio of 15, and its future profits are expected to decline by 20%. Due to this decline in profits, the market begins to have doubts about the company's future, and investors start to lower its P/E ratio. For example, the P/E ratio could drop from 15 to 12. As a result, the stock price may significantly fall, for example:
Current stock price: $100
Profits decline by 20%, meaning earnings per share (EPS) drop from $5 to $4.
The price-to-earnings ratio decreases from 15 to 12.
New stock price: $4 × 12 = $48
The stock price drops from $100 to $48, reflecting the dual impact of declining profits and valuation contraction.
This resonance effect typically occurs in high-growth stocks, especially in many tech stocks, as investors are often willing to give these companies a higher expected future growth. However, this expectation usually has significant subjective factors, thus corresponding volatility is also quite large.
How is MSTR's high premium generated, and why does it become the core of its business model
With this background knowledge supplemented, I believe everyone should be able to roughly understand how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy has switched its business from traditional software to financing for purchasing BTC, and future asset management revenue cannot be ruled out. This means that the company's profits come from capital gains on BTC purchased with funds obtained through equity dilution and bond issuance. Along with the appreciation of BTC, the shareholders' equity of all investors 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 ability, as MSTR investors' expectations for the company's future profit growth are derived from the leverage gains obtained through its financing capabilities. Given that MSTR's total market capitalization is in a state of positive premium relative to the total value of its BTC holdings, it indicates that MSTR's total market capitalization is higher than its total BTC value. As long as it remains in this state of positive premium, both equity financing and its convertible bond financing, along with the funds obtained being used to purchase BTC, will further increase per-share equity. This gives MSTR a profit growth capability different from that of BTC ETFs.
To illustrate, suppose the current BTC held by MSTR is $40 billion, with total shares X and total market capitalization Y. At this time, the equity per share is $40 billion / X. Assuming the worst-case scenario of equity dilution for financing, if the new share issuance ratio is a, this means total shares become X (a + 1). If we complete financing at the current valuation, a total of a Y billion dollars is raised. If all this capital is converted into BTC, then the BTC holdings change to $40 billion + a * Y billion, meaning equity per share becomes:
We will subtract this from the original per-share equity to calculate the effect of diluted equity on per-share equity growth as follows:
This means that when Y is greater than $40 billion, which is the value of its BTC holdings, it indicates the existence of a positive premium, resulting in the per-share equity growth from financing for the purchase of BTC being always greater than 0, and the larger the positive premium, the higher the per-share equity growth. The two have a linear relationship, while the impact of the dilution ratio a displays a reciprocal characteristic in the first quadrant, meaning the fewer shares are issued, the higher the equity growth.
Therefore, for Michael Saylor, the positive premium of MSTR's market value relative to the value of its BTC holdings is the core factor for the validity of its business model. Thus, his optimal choice is how to maintain this premium while continuously financing, increasing his market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will also bolster investor confidence in future growth despite high P/E ratios, enabling fundraising.
To summarize, the secret of MicroStrategy's business model lies in the appreciation of BTC driving an increase in company profits, and the positive growth trend of BTC indicates a favorable trend in corporate profit growth. With this support of the 'Davis Double Play', the positive premium of MSTR begins to expand. Therefore, the market is betting on how high a positive premium valuation MicroStrategy can achieve for subsequent financing.
What risks does MicroStrategy pose to the industry?
Next, let's discuss the risks that MicroStrategy brings to the industry. I believe the core lies in the fact that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of volatility. The reason is the 'Davis Double Kill', and the period of BTC entering a high-level oscillation is the stage at which the entire domino effect begins.
Let us imagine that when the rise of BTC slows down and enters a phase of oscillation, MicroStrategy's profits will inevitably begin to decline. Here, I want to elaborate that I see some friends very focused 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 real factors causing stock price fluctuations are earnings reports; only when quarterly earnings reports are released will the true profit level be confirmed by the market. In the interim, investors can only estimate changes in financial situations based on some external information. In other words, for most of the time, stock prices lag behind real earnings changes. This lagging relationship will be corrected when each quarterly earnings report is released. However, in MicroStrategy's business model, since both its holdings and the price of BTC are public information, investors can understand its true profit level in real-time, and there is no lag effect because per-share equity changes dynamically, equivalent to real-time profit settlement. Since this is the case, stock prices already reflect all its profits, and there is no lag effect, thus it is meaningless to focus on holding costs.
Pulling the topic back, let’s look at how 'Davis Double Kill' unfolds. When BTC's growth slows down and enters a phase of oscillation, MicroStrategy's profits will continuously decline, potentially even to zero. At this time, fixed operating costs and financing costs will further shrink the company's profits, potentially even leading to losses. This oscillation will continually erode market confidence in the future development of BTC prices. This will translate into questions about MicroStrategy's financing ability, further undermining expectations for its profit growth. In this resonance, MSTR's positive premium will rapidly converge. To maintain the validity of its business model, Michael Saylor must uphold the state of positive premium. Therefore, selling BTC to buy back shares is a necessary operation, which marks the moment MicroStrategy begins selling 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, it cannot be done when the BTC price reverses. During oscillation, it can be tolerated to some extent, due to MicroStrategy's current equity structure and what constitutes the optimal solution for Michael Saylor.
According to the current shareholding ratio of MicroStrategy, there are several top-tier consortiums, such as Jane Street and BlackRock, while founder Michael Saylor holds less than 10%. Of course, through the dual-class share structure, Michael Saylor's voting rights have an absolute advantage, as he holds more B-class common shares, which have a voting power ratio of 10:1 compared to A-class shares. Thus, this company is still under Michael Saylor's strong control, but his shareholding is not high.
This means that for Michael Saylor, the company's long-term value is far greater than the value of its BTC holdings, because if the company faces bankruptcy liquidation, it would not recover much BTC.
So what are the benefits of selling BTC to buy back shares during the oscillation phase? The answer is also evident. When the premium converges, if Michael Saylor determines that MSTR's P/E ratio is undervalued due to panic, then selling BTC to obtain funds and repurchasing MSTR from the market is a worthwhile operation. Therefore, at this time, the effect of reducing the float through buybacks will amplify the per-share equity effect more than the effect of reducing per-share equity due to the decrease in BTC reserves. When the panic ends and the stock price rebounds, per-share equity will thus become higher, benefiting future development. This effect is easier to understand in extreme cases when BTC's trend reverses, and MSTR experiences a negative premium.
Considering Michael Saylor's holdings, when oscillation or downward cycles occur, liquidity is typically tightened. When it starts to sell, the price of BTC will drop, leading to a faster decline. This acceleration of decline will further worsen investors' expectations for MicroStrategy's profit growth, and the premium rate will further decrease, potentially forcing it to sell BTC to buy back MSTR. At this point, the 'Davis Double Kill' begins.
Of course, another reason forcing it to sell BTC to maintain the stock price is that its investors are a group of powerful Deep State individuals who cannot just watch the stock price go to zero without taking action, inevitably putting pressure on Michael Saylor to shoulder the responsibility for managing its market value. Furthermore, recent information indicates that with continued equity dilution, Michael Saylor's voting power has fallen below 50%. However, I have not found specific sources for this news. Yet this trend seems unavoidable.
Does MicroStrategy's convertible bond truly have no risks before maturity?
After the above discussion, I believe I have completely articulated my logic. I also hope to discuss a topic: Does MicroStrategy have no debt risk in the short term? Some predecessors have introduced the nature of MicroStrategy's convertible bonds, and I won't elaborate on that here. Indeed, its debt maturity is quite long. Before the maturity date comes, there is indeed no repayment risk. However, my view is that its debt risk could still be anticipated through stock prices.
The convertible bonds issued by MicroStrategy are essentially bonds layered with free call options. Upon maturity, creditors can require MicroStrategy to redeem them at the previously agreed conversion rate equal to stock value. However, there is also protection for MicroStrategy, as it can choose the redemption method, either in cash, stock, or a combination of both. This allows for some flexibility; if funds are sufficient, it can repay more in cash to avoid dilution of equity. If funds are tight, it can provide more stock. Moreover, this convertible bond is unsecured, so the risks associated with debt repayment are not significant. Furthermore, there is protection for MicroStrategy, as if the premium rate exceeds 130%, MicroStrategy can choose to redeem it directly at cash par value, creating conditions for refinancing negotiations.
Thus, the creditors of this debt will only have capital gains if the stock price is above the conversion price and below 130% of the conversion price; otherwise, they will only have principal plus low interest. Of course, after being reminded by teacher Mindao, the main investors in this bond are still hedge funds using it for Delta hedging to earn volatility returns. Therefore, I have thought through the underlying logic.
Delta hedging through convertible bonds primarily involves buying MSTR convertible bonds while short-selling an equivalent amount of MSTR stock to hedge against risks from stock price fluctuations. Moreover, as prices develop thereafter, hedge funds need to continuously adjust their positions for dynamic hedging. Dynamic hedging usually has the following two scenarios:
When MSTR's stock price falls, the Delta value of the convertible bond decreases because the bond's conversion rights become less valuable (closer to 'out of the money'). At this point, more MSTR stock needs to be short-sold to match the new Delta value.
When MSTR's stock price rises, the Delta value of the convertible bond increases because the bond's conversion rights become more valuable (closer to 'in the money'). At this point, some of the previously short-sold MSTR stock should be bought back to match the new Delta value, thereby maintaining the hedging of the portfolio.
Dynamic hedging needs to be frequently adjusted under the following circumstances:
Significant fluctuations in the underlying stock price: For example, drastic changes in Bitcoin prices lead to sharp fluctuations in MSTR's stock price.
Changes in market conditions: For example, volatility, interest rates, or other external factors affect the convertible bond pricing model.
Hedge funds typically trigger operations based on the magnitude of changes in Delta (for instance, for 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 position is as follows:
Buying $10 million worth of MSTR convertible bonds (Delta = 0.6).
Short selling $6 million worth of MSTR stock.
When the stock price rises from $100 to $110, the Delta value of the convertible bond changes to 0.65, necessitating an adjustment of stock positions. The calculation for the number of shares to be replenished is (0.65 − 0.6) × 10 million = 500,000. The specific operation is to buy back $500,000 worth of stock.
When the stock price drops from $100 to $95, the new Delta value of the convertible bond becomes 0.55, requiring an adjustment of stock positions. The calculation shows that an additional short position of (0.6 − 0.55) × 10 million = 500,000 shares is necessary. The specific operation is to short $500,000 worth of stock.
This means that when MSTR's price drops, the hedge funds behind its convertible bonds will short-sell more MSTR stock to dynamically hedge Delta, further impacting MSTR's stock price negatively, affecting the positive premium and thus impacting the entire business model. Therefore, the risks from the bond side will feedback through the stock price in advance. Of course, in MSTR's upward trend, hedge funds will buy more MSTR, so it is also a double-edged sword.
