Wu says Real December 02, 2024 09:00 Shandong
The following article is from Miao Xiaoao looks at Web3, author Mario looks at Web3
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Author | @Web3_Mario
Summary: This week has a very interesting theme, which is the popularity of MicroStrategy, many predecessors have commented on the company's operational model. After digesting and researching, I have some personal views that I would like to share. I believe the reason for MicroStrategy's stock price increase is due to the 'Davis Double Play'. By designing a business model that finances the purchase of BTC, it ties the appreciation of BTC to the company's profits and leverages funds obtained through innovative designs that combine traditional financial market financing channels, enabling the company to achieve profit growth beyond the appreciation of its held BTC. Meanwhile, as the holdings increase, the company gains a certain pricing power over BTC, further reinforcing this profit growth expectation. Its risk lies in this: when BTC market experiences volatility or reversal risks, the profit growth of BTC will stagnate, while affected by the company's operating expenses and debt pressure, MicroStrategy's financing ability will be significantly reduced, thus impacting profit growth expectations. Unless new support can take over to further boost BTC prices, the positive premium of MSTR stock price relative to BTC holdings will quickly converge, a process known as '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, thus replaying my own thought logic. Therefore, first, let’s 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, and is usually used to describe a phenomenon where a company's stock price rises sharply due to two factors in a good economic environment. These two factors are:
· Company profit growth: The company has achieved strong profit growth, or optimizations in its business model, management, etc., have led to profit increases.
· Valuation expansion: As the market becomes more optimistic about the company's prospects, investors are willing to pay a higher price for it, thus driving up the stock's valuation. In other words, the price-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 profit growing. For example, strong product sales, expanded market share, or successful cost control, all of which directly lead to the company's profit growth. This growth will simultaneously enhance the market's confidence in the company's future prospects, leading investors to accept a higher price-earnings ratio P/E and pay a higher price for the stock, resulting in valuation expansion. This linear and exponential combined positive feedback effect usually leads to the stock price accelerating upward, known as the 'Davis Double Play'.
To illustrate this process, suppose a company currently has a price-earnings ratio of 15 times, and its future earnings are expected to grow by 30%. If due to the company's profit growth and changes in market sentiment, investors are willing to pay 18 times the price-earnings ratio, then even if the profit growth rate remains unchanged, the increase in valuation will drive the stock price sharply upward, for example:
Current stock price: $100
Profit growth of 30% means earnings per share (EPS) increase from $5 to $6.5
Price-earnings ratio increases from 15 to 18
New stock price: $6.5×18 = $117
The stock price rose from $100 to $117, reflecting the dual effect of profit growth and valuation increase.
On the other hand, 'Davis Double Kill' is the opposite, usually used to describe a rapid decline in stock prices under the combined action of two negative factors. These two negative factors are:
· Company profit decline: The company's profitability declines, possibly due to decreased revenue, increased costs, management mistakes, etc., leading to profits below market expectations.
· Valuation contraction: Due to declining profits or worsening market prospects, investors' confidence in the company's future declines, leading to a decrease in its valuation multiples (such as price-earnings ratio) and a drop in stock price.
The overall logic is as follows: first, the company fails to meet expected profit targets or faces operational difficulties, resulting in poor performance and declining profits. This will further make the market's expectations for its future deteriorate, leading to insufficient investor confidence, unwilling to accept the currently inflated price-earnings ratio, and only willing to pay lower prices for the stock, causing a decrease in valuation multiples and further decline in stock prices.
Similarly, to illustrate this process, suppose a company currently has a price-earnings ratio of 15 times, and its future earnings are expected to decline by 20%. Due to the decrease in earnings, the market begins to doubt the company's future prospects, and investors start to lower its price-earnings ratio. For example, lowering it from 15 to 12. The stock price may therefore fall sharply, for example:
Current stock price: $100
Profit decline of 20% means earnings per share (EPS) decrease from $5 to $4
Price-earnings ratio decreases from 15 to 12
New stock price: $4×12 = $48
The stock price fell 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 often willing to set higher expectations for future growth in these companies. However, this expectation usually has significant subjective factors supporting it, so the corresponding volatility is also substantial.
How MSTR's high premium is generated and why it becomes the core of its business model
With this background knowledge supplemented, I think 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 model from traditional software business to financing the purchase of BTC, and it does not rule out corresponding asset management revenue in the future. This means that the company's profit comes from the capital gains of BTC appreciation obtained through equity dilution and debt issuance. As BTC appreciates, all investors' shareholder equity will correspondingly increase, benefiting investors, in this regard, MSTR is no different from other BTC ETFs.
What distinguishes this is the leverage effect brought by its financing ability, because MSTR investors' expectations for the company's future profit growth come from the leverage gains obtained from its financing capacity. Considering that MSTR's total market value relative to its held BTC total value is in a positive premium state, in other words, MSTR's total market value is higher than its held BTC total value. As long as it is in this positive premium state, whether through equity financing or its convertible bond financing, along with the funds obtained to purchase BTC, it will further increase per-share equity. This gives MSTR a profit growth capability different from that of BTC ETFs.
For example, suppose the current value of BTC held by MSTR is $40 billion, total outstanding shares X, and its total market value is Y. At this time, per-share equity is $40 billion / X. In the worst-case scenario of equity dilution through financing, if the proportion of new shares issued is a, this means total outstanding shares become X * (a+1), and if financing is completed at the current valuation, it will raise a * Y billion dollars. If all these funds are converted into BTC, the BTC holdings will become $40 billion + a * Y billion, meaning per-share equity will become:
We will subtract it from the original per-share equity to calculate the dilution effect on per-share equity growth as follows:
This means that when Y exceeds $40 billion, i.e., the value of its held BTC, it indicates a positive premium, and the per-share equity growth resulting from financing to purchase BTC will always be greater than 0. The larger the positive premium, the higher the per-share equity growth, and the two have a linear relationship. Regarding the influence of the dilution ratio a, it presents an inverse proportional characteristic in the first quadrant, meaning that the fewer new shares issued, the higher the equity growth.
Therefore, for Michael Saylor, the positive premium of MSTR's market value relative to its held BTC value is the core factor for the viability 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 strengthen investors' confidence in future growth even at high price-earnings ratios, enabling him to complete fundraising.
To summarize, the secret of MicroStrategy's business model lies in the fact that the appreciation of BTC drives up the company's profits, and a favorable growth trend in BTC implies a favorable growth trend for the company's profits. Under this support of 'Davis Double Play', MSTR's positive premium begins to amplify, so the market is betting on how high a positive premium valuation MicroStrategy can achieve 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 the fact that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of volatility. The reason lies in 'Davis Double Kill', and BTC entering a high-level volatile period is the beginning of the entire domino effect.
Let's imagine that when the growth of BTC slows down and enters a volatile period, MicroStrategy's profits will inevitably start to decline. Here I want to elaborate that I see some partners very concerned about their holding costs and the scale of floating profits. 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 financial reports. Only when quarterly financial reports are released can the real profit levels be confirmed by the market. In the meantime, investors only estimate changes in financial conditions based on some external information. In other words, for most of the time, stock price reactions lag behind the company's actual revenue changes. This lagging relationship is corrected when each quarterly financial report is released. However, in MicroStrategy's business model, since its holding scale and BTC prices are public information, investors can understand its real profit level in real-time, and there is no lag effect because per-share equity changes dynamically, equivalent to real-time profit settlement. Therefore, the stock price already reflects all its profits, and there is no lag effect, making it meaningless to focus on its holding costs.
Bringing the topic back, let's see how 'Davis Double Kill' unfolds. When BTC's growth slows and enters a fluctuation phase, MicroStrategy's profits will continue to decline, potentially even to zero. At this time, fixed operating costs and financing costs will further shrink the company's profits, potentially leading to a state of loss. At this time, this fluctuation will continuously erode the market's confidence in the future BTC price development. This will translate into doubts about MicroStrategy's financing capacity, further negatively impacting profit growth expectations. Under the resonance of these two factors, MSTR's positive premium will quickly converge. To maintain the viability of its business model, Michael Saylor must maintain the state of positive premium. Therefore, selling BTC to raise funds to repurchase stock is a necessary operation, and this is the moment MicroStrategy begins to sell its first BTC.
Some partners may ask, can't you just hold onto BTC and let the stock price naturally drop? My answer is no, more precisely, it is not possible when the BTC price reverses; during volatility, it can be tolerated to some extent. The reason is that MicroStrategy's current equity structure and what is the optimal solution for Michael Saylor.
Based on the current holding ratio of MicroStrategy, there are several top-tier consortia, such as Jane Street and BlackRock, while the founder Michael Saylor holds less than 10%. Of course, through the dual-class share structure, Michael Saylor's voting rights have absolute advantage since he holds more Class B common stock, and the voting rights of Class B common stock are 10:1 compared to Class A. Therefore, this company is still under the strong control of Michael Saylor, but his equity share 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, because assuming the company faces bankruptcy liquidation, it will not be able to obtain much BTC.
So what are the benefits of selling BTC during the volatility phase and repurchasing stock to maintain the premium? The answer is obvious: when a premium convergence occurs, if Michael Saylor judges that MSTR's price-earnings ratio is undervalued due to panic, it would be a profitable operation to sell BTC for cash and repurchase MSTR from the market. Therefore, at this time, the effect of repurchase on reducing circulation and amplifying per-share equity will outweigh the effect of reducing per-share equity due to the decrease in BTC reserves. After the panic ends, the stock price will rebound, and per-share equity will thus become higher, benefiting subsequent development. This effect is easier to understand in extreme cases of BTC trend reversals when MSTR experiences a negative premium.
Considering the current holding volume of Michael Saylor, and when fluctuations or downtrends occur, liquidity is usually tightened. When it starts to sell, the price of BTC will drop rapidly. The acceleration of the drop will further worsen investors' expectations for MicroStrategy's profit growth, leading to a lower premium rate, and this may force it to sell BTC to repurchase MSTR, marking the beginning of 'Davis Double Kill'.
Of course, another reason that forces it to sell BTC to maintain stock prices is that the investors behind it are a group of well-connected Deep State individuals, who cannot sit idly by and watch the stock price drop to zero, inevitably putting pressure on Michael Saylor and forcing him to take responsibility for managing the market value. Additionally, recent news indicates that with continuous equity dilution, Michael Saylor's voting power has fallen below 50%. Although I have not found specific sources for this information, this trend seems unavoidable.
Does MicroStrategy's convertible bonds really have no risk before maturity?
After the above discussion, I think I have fully 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, which I will not elaborate on here. Indeed, its debt duration is quite long. Before the maturity date arrives, there is indeed no repayment risk. However, my point is that its debt risk may still be feedback through stock prices in advance.
MicroStrategy's issued convertible bonds are essentially bonds that combine free call options. Upon maturity, creditors can require MicroStrategy to redeem in stock equivalent to the previously agreed conversion rate. However, there is also protection for MicroStrategy: MicroStrategy can actively choose the redemption method, using cash, stock, or a combination of both, which is relatively flexible. If funds are sufficient, it can pay more cash to avoid dilution of equity. If funds are insufficient, then it can offer more stock. Moreover, this convertible bond is unsecured, so the risk of debt repayment is indeed not high. Additionally, there is another protection for MicroStrategy: if the premium rate exceeds 130%, MicroStrategy can also choose to redeem directly at cash par value, which creates favorable conditions for refinancing negotiations.
Thus, the bondholders will only have capital gains when the stock price is above the conversion price, and below 130% of the conversion price; otherwise, they only receive principal plus low interest. Of course, after being reminded by Teacher Mindao, the main investors in this bond are hedge funds using it for Delta hedging to earn volatility returns. Therefore, I thought more deeply about the underlying logic.
Delta hedging through convertible bonds specifically involves purchasing MSTR convertible bonds while shorting an equal amount of MSTR stock to hedge against risks from stock price fluctuations. Moreover, as the subsequent price develops, 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 conversion rights of the bonds become less valuable (closer to 'out of the money'). At this time, 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 because the conversion rights of the bonds become more valuable (closer to 'in the money'). At this time, buying back some previously shorted MSTR stock is needed to match the new Delta value and maintain the hedging of the portfolio.
Dynamic hedging needs to be frequently adjusted under the following circumstances:
· Significant fluctuations in the underlying stock price: such as large changes in Bitcoin prices leading to violent fluctuations in MSTR's stock price.
· Changes in market conditions: such as volatility, interest rates, or other external factors affecting the convertible bond pricing model.
· Hedge funds typically trigger operations based on the magnitude of changes in Delta (e.g., every change of 0.01) to maintain precise hedging of the portfolio.
Let’s take a specific scenario to illustrate this, suppose a hedge fund's initial holdings are as follows:
· Buying $10 million worth of MSTR convertible bonds (Delta = 0.6).
· Shorting $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 adjustment of the stock position. The calculation for the number of shares to be repurchased 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, requiring adjustment of the stock position. The calculation for the increase in shorted 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 falls, the hedge fund behind the convertible bonds will short more MSTR stock to dynamically hedge Delta, further impacting MSTR's stock price, which will negatively affect the positive premium and thus impact the entire business model. Therefore, the risks on the bond side will be feedback through the stock price in advance. Of course, in MSTR's upward trend, hedge funds will buy more MSTR, so it's also a double-edged sword.
