Author | @Web3_Mario
Abstract: This week, there is an interesting theme regarding the heat surrounding MicroStrategy. Many predecessors have commented on the operational model of this company. After digesting and researching it deeply, I have some of my own views that I hope to share with everyone. I believe the reason for the rise in MicroStrategy's stock price lies in the 'Davis Double Play'. By designing financing to purchase BTC, it binds the appreciation of BTC to corporate profits and leverages funds obtained through innovative designs in traditional financial market financing channels, enabling the company to achieve earnings growth beyond the appreciation of BTC it holds. Meanwhile, with the expansion of its holdings, the company possesses a certain pricing power over BTC, further strengthening this earnings growth expectation. However, the risk also lies here. When BTC's market experiences fluctuations or reversal risks, the earnings growth from BTC will stagnate, and under the influence of the company's operating expenses and debt pressures, MicroStrategy's financing ability will be significantly reduced, thus affecting earnings growth expectations. Unless there are new drivers to further boost BTC prices, the positive premium of MSTR's stock price relative to its BTC holdings will quickly converge. This process is referred to as the 'Davis Double Kill.'
What are the Davis Double Play and Double Kill?
Friends who are familiar with me should know that I am committed to helping more non-financial professionals understand these dynamics, so I will replay my thought process. Therefore, I will first supplement some basic knowledge regarding 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 a phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment. These two factors are:
· Company earnings growth: The company has achieved strong earnings growth, or its business model, management, and other aspects have been optimized, leading to increased profits.
· Valuation expansion: As the market becomes more optimistic about the company's prospects, investors are willing to pay a higher price, 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 income and profits growing. For example, strong product sales, expanded market share, or successful cost control will directly lead to the company's earnings growth. This growth will also enhance market confidence in the company's future prospects, causing investors to be willing to accept a higher P/E ratio and pay a higher price for the stock, leading to an expansion of valuation. This linear and exponential combined positive feedback effect usually causes stock prices to accelerate upward, which is known as the 'Davis Double Play.'
To illustrate this process, suppose a company's current price-to-earnings ratio is 15 times, and its future earnings are expected to grow by 30%. If, due to the growth of the company's earnings and changes in market sentiment, investors are willing to pay an 18 times P/E ratio, even if the earnings growth rate remains unchanged, the increase in valuation will drive the stock price significantly higher. For example:
Current stock price: $100
Earnings growth of 30%, meaning earnings per share (EPS) increases from $5 to $6.5
Price-to-earnings ratio increases from 15 to 18
New stock price: $6.5 × 18 = $117
The stock price rises from $100 to $117, reflecting the dual effects of earnings growth and valuation increase.
The 'Davis Double Kill' is the opposite, usually used to describe a rapid decline in stock prices due to the combined effect of two negative factors. These two negative factors are:
· Company earnings decline: The company's profitability decreases, possibly due to reduced income, increased costs, management errors, and other factors, leading to profits below market expectations.
· Valuation contraction: Due to declining earnings or worsening market prospects, investors' confidence in the company's future declines, leading to a decrease in valuation multiples (such as P/E ratio) and falling stock prices.
The entire logic is as follows: First, the company fails to meet its expected profit targets or faces operational difficulties, leading to poor performance and declining profits. This will further worsen market expectations for its future, causing investor confidence to decline, making them unwilling to accept the currently overvalued P/E ratio, and only willing to pay lower prices for the stock, resulting in a decrease in valuation multiples and further declines in stock prices.
Similarly, to illustrate this process, suppose a company's current price-to-earnings ratio is 15 times, and its future earnings are expected to decline by 20%. Due to declining earnings, the market begins to have doubts about the company's prospects, causing investors to lower its P/E ratio. For example, reducing the P/E ratio from 15 to 12. The stock price may therefore drop significantly, such as:
Current stock price: $100
Earnings decline of 20%, meaning earnings per share (EPS) drops from $5 to $4
Price-to-earnings ratio decreases from 15 to 12
New stock price: $4 × 12 = $48
The stock price falls from $100 to $48, reflecting the dual effects of declining earnings and valuation contraction.
This resonance effect usually occurs in high-growth stocks, especially evident in many technology stocks, as investors are typically willing to give higher expectations for these companies' future growth. However, such expectations often have considerable subjective factors supporting them, leading to significant volatility.
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 rough understanding of how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy has switched its business from traditional software operations to financing purchases of BTC, and it does not rule out future revenue from asset management. This means this company's profit comes from the capital gains of BTC appreciation bought with funds obtained through equity dilution and bond issuance. As BTC appreciates, all investors' shareholder equity will correspondingly increase, benefiting investors. In this respect, MSTR is no different from other BTC ETFs.
The difference arises from its financing ability bringing leverage effects since MSTR investors' expectations for future earnings growth come from the increased leverage obtained through its financing capacity. Considering that MSTR's total market capitalization is at a premium relative to the total value of its held BTC, it means MSTR's total market value is higher than the total value of its held BTC. As long as it remains in this premium state, whether through equity financing or convertible bond financing, the funds acquired to purchase BTC will further increase equity per share. This gives MSTR a different capacity for earnings growth compared to a BTC ETF.
To illustrate, suppose the current BTC held by MSTR is $40 billion, the total outstanding shares are X, and its total market value is Y. Then, equity per share would be $40 billion / X. Assuming the most unfavorable scenario of equity dilution for financing, if the new share issuance ratio is a, this means the total outstanding shares become X × (a + 1). With the current valuation, financing would raise a × Y billion dollars. If all these funds are converted into BTC, the BTC holdings would change from $40 billion to $40 billion + a × Y billion, meaning equity per share becomes:
We will subtract it from the original equity per share to calculate the effect of diluted equity growth per share, as follows:
This means that when Y is greater than $40 billion, which is its held BTC value, it implies the existence of a positive premium. Completing financing to purchase BTC will bring about an increase in equity per share greater than 0, and the greater the positive premium, the higher the increase in equity per share. The two are linearly related, and regarding the impact of dilution ratio a, it presents an inverse feature in the first quadrant, meaning 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 its held BTC is the core factor for the establishment of its business model. Thus, his optimal choice is how to maintain this premium while continuously financing, increasing his market share, and obtaining more pricing power over BTC. The continuous enhancement of pricing power will also strengthen investors' confidence in future growth at high P/E ratios, enabling him to complete fundraising.
To summarize, the mystery of MicroStrategy's business model lies in the appreciation of BTC driving an increase in corporate profits, and a positive growth trend in BTC implies a positive trend in corporate earnings growth. With the support of this 'Davis Double Play', MSTR's premium begins to expand. Therefore, the market is gambling on how high a positive premium valuation MicroStrategy can achieve for subsequent financing.
What risks does MicroStrategy bring to the industry?
Next, let's discuss the risks that MicroStrategy brings to the industry. I believe its core lies in the fact that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of that volatility. The reason for this is the 'Davis Double Kill,' and BTC entering a high-level consolidation period is the stage where the entire domino effect begins.
Let's imagine that when BTC's growth slows and enters a consolidation phase, MicroStrategy's earnings will inevitably begin to decline. Here, I want to elaborate on this point, 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 essentially settled in real-time. In the traditional stock market, we know that the factors causing stock price fluctuations are financial reports. Only when quarterly earnings reports are released will the true profit level be confirmed by the market. In the meantime, investors merely estimate changes in financial conditions based on some external information. This means that, for most of the time, the stock price's reaction lags behind the company's actual earnings changes. This lagging relationship will be corrected when each quarterly earnings report is announced. However, in MicroStrategy's business model, as the scale of its holdings and the price of BTC are both public information, investors can understand its real profitability in real-time, and there is no lag effect. Each share of equity changes dynamically, equating to real-time profit settlement. Therefore, the stock price has already reflected all its profits without a lag effect. Thus, paying attention to its holding cost is meaningless.
Bringing the topic back, let's see how the 'Davis Double Kill' unfolds. When BTC's growth slows and enters a consolidation phase, MicroStrategy's earnings will continuously decline, even possibly to zero. At this time, fixed operating costs and financing costs will further reduce corporate profits, potentially leading to losses. This ongoing fluctuation will gradually erode market confidence in the future price development of BTC, which will translate into doubts about MicroStrategy's financing ability, further undermining expectations for its earnings growth. Under the resonance of both factors, MSTR's premium will quickly converge. To maintain the viability of its business model, Michael Saylor must uphold the premium status. Therefore, selling BTC to buy back shares is a necessary action, and this is when MicroStrategy began selling its first BTC.
Some friends may ask, why not just hold BTC and let the stock price fall naturally? My answer is no; to be more precise, it cannot be done when BTC's price reverses, while it can be tolerated during fluctuations. The reason lies in 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%. However, through a dual-class share structure, Michael Saylor's voting power has an absolute advantage because he holds more Class B common stock, which has a voting power ratio of 10:1 compared to Class A. Therefore, this company is still under the strong control of Michael Saylor, but his shareholding ratio is not high.
This means that for Michael Saylor, the company's long-term value is far greater than the value of its held BTC, since in the event of bankruptcy liquidation, the BTC it can obtain would be limited.
So what are the benefits of selling BTC during the consolidation phase and repurchasing shares to maintain the premium? The answer is obvious. When there is a convergence of premium, if Michael Saylor judges that MSTR's P/E ratio is undervalued due to panic, then selling BTC for cash and repurchasing MSTR from the market becomes a profitable operation. Therefore, at this time, the effect of repurchasing on reducing circulation will amplify the increase in equity per share, more than the effect of reduced BTC reserves on shrinking equity per share. When the panic ends and the stock price rebounds, equity per share will therefore become higher, benefiting future development. This effect is easier to understand in extreme cases when BTC's trend reverses and MSTR appears at a negative premium.
Considering Michael Saylor's current holdings, when fluctuations or downturns occur, liquidity usually tightens. Therefore, when he starts selling, the price of BTC will decline rapidly. The accelerated decline will further worsen investors' expectations for MicroStrategy's earnings growth, causing the premium to drop further, which may force him to sell BTC to repurchase MSTR. This is when the 'Davis Double Kill' begins.
Of course, there is another reason forcing it to sell BTC to maintain its stock price, which is that the investors behind it are a group of powerful Deep State actors who cannot remain indifferent while the stock price approaches zero. This will inevitably put pressure on Michael Saylor and force him to take responsibility for managing the company's market value. Moreover, recent information shows that with ongoing equity dilution, Michael Saylor's voting power has fallen below 50%, although I haven't found the exact source for this news. However, this trend seems unavoidable.
Does MicroStrategy's convertible bond really have no risk before maturity?
After the discussion above, I believe I have fully articulated my logic. I also hope to discuss a topic: Does MicroStrategy really have no debt risk in the short term? Some predecessors have already introduced the nature of MicroStrategy's convertible bonds, so I won't elaborate on that here. Indeed, its debt duration is quite long. There is no repayment risk before the maturity date. However, my view is that its debt risk may still be reflected in the stock price in advance.
The convertible bonds issued by MicroStrategy are essentially bonds with a free call option overlay. Upon maturity, bondholders can require MicroStrategy to redeem them with stock equivalent to the previously agreed conversion rate. However, there are protections for MicroStrategy as well, allowing it to choose the redemption method, whether 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 equity dilution. If funds are tight, it can issue more stock. Moreover, these convertible bonds are unsecured, so the risks associated with debt repayment are not significant. Additionally, if the premium rate exceeds 130%, MicroStrategy can also choose to redeem at par in cash, creating conditions for refinancing negotiations.
So the creditors of this debt will only gain capital gains when the stock price is above the conversion price and below 130% of the conversion price, aside from that, there is only principal plus low interest. Of course, after being reminded by Professor Mindao, the investors of this bond are mainly hedge funds using it for Delta hedging to earn volatility returns. Therefore, I have thought carefully about the underlying logic.
Delta hedging through convertible bonds specifically involves purchasing MSTR convertible bonds while shorting an equivalent amount of MSTR stock to hedge against risks arising from stock price fluctuations. Moreover, as the price develops subsequently, hedge funds need to continuously adjust positions for dynamic hedging. Dynamic hedging typically has the following two scenarios:
· When MSTR's stock price drops, the Delta value of the convertible bond decreases, as the conversion rights of the bond become less valuable (closer to 'out of the money'). At this point, more MSTR stock needs to be shorted to match the new Delta value.
· When MSTR's stock price rises, the Delta value of the convertible bond increases, as the conversion rights of the bond become more valuable (closer to 'in the money'). At this point, some previously shorted MSTR stock is bought back to match the new Delta value, thus maintaining the hedging of the portfolio.
Dynamic hedging needs to be frequently adjusted in the following situations:
· Significant stock price volatility: Such as substantial changes in Bitcoin prices leading to dramatic fluctuations in MSTR's stock price.
· Changes in market conditions: Such as volatility, interest rates, or other external factors affecting convertible bond pricing models.
· Hedge funds typically trigger operations based on changes in Delta (e.g., every 0.01 change) to maintain precise hedging of their portfolios.
Let's illustrate this with a specific scenario. Assume an initial position of a hedge fund is as follows
· Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).
· Short $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, so stock positions need to be adjusted. The calculation for the stock to be bought back 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 falls from $100 to $95, the new Delta value of the convertible bond becomes 0.55, necessitating an adjustment of the stock position. The calculation for the required increase in short stock is (0.6 - 0.55) × 10 million = 500,000. The specific operation is to short $500,000 worth of stock.
This means that when MSTR's price drops, the hedge funds behind the convertible bonds will short more MSTR stock to dynamically hedge Delta, further driving down MSTR's stock price, and this will negatively impact the positive premium, thus affecting the entire business model. Therefore, the risks on the bond side will feedback through stock prices in advance. Of course, during the upward trend of MSTR, hedge funds will buy more MSTR, so it is also a double-edged sword.
