MicroStrategy's business model will significantly increase the volatility of BTC prices, acting as an amplifier of volatility.
Author: @Web3_Mario
Summary: Last week we discussed Lido's potential to benefit from regulatory changes, hoping to help everyone seize this Buy the rumor trading opportunity. This week there is a very interesting theme, which is the popularity of MicroStrategy. Many predecessors have commented on this company's operating model. After digesting and studying it in depth, I have some of my own views that I would like to share with you. I believe the reason for MicroStrategy's stock price increase lies in the 'Davis Double Play'. Through the business design of financing to purchase BTC, linking the appreciation of BTC with company profits, and leveraging funds obtained through innovative designs that combine traditional financial market financing channels, the company has the ability to exceed the profit growth brought by the appreciation of its held BTC. At the same time, as the holding volume expands, the company gains a certain pricing power over BTC, further strengthening this profit growth expectation. However, the risk lies here. When the BTC market experiences volatility or reversal risks, profit growth from BTC will stagnate. At the same time, affected by the company's operating expenses and debt pressure, MicroStrategy's financing ability will be significantly discounted, thus affecting profit growth expectations. Unless there is new support to further push BTC prices, otherwise MSTR's stock price relative to BTC holdings' positive premium will quickly converge, this process is known as the 'Davis Double Kill'.
What are Davis Double Play and Double Kill?
Familiar friends 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 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:
l Company profit growth: The company achieves strong profit growth, or optimizations in its business model, management, etc., lead to increased profits.
l Valuation expansion: Due to the market's more optimistic outlook on the company's prospects, investors are willing to pay a higher price, thus driving up stock valuations. In other words, the stock's price-to-earnings (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 profit growth. This growth will also 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 valuation to begin to expand. This combination of linear and exponential positive feedback effects often results in stock prices accelerating upward, known as the 'Davis Double Play.'
To illustrate this process, suppose a company's current P/E ratio is 15 times, 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 18 times the P/E ratio, even if the profit growth rate remains unchanged, the increase in valuation will drive the stock price to rise significantly, for example:
l Current stock price: $100
l Profit growth of 30%, meaning earnings per share (EPS) increased from $5 to $6.5.
l P/E ratio increased from 15 to 18.
l New stock price: $6.5 × 18 = $117
The stock price rises from $100 to $117, reflecting the dual effects of profit growth and valuation enhancement.
The 'Davis Double Kill' is the opposite, usually used to describe a rapid drop in stock prices under the combined effect of two negative factors. These two negative factors are:
l Company profit decline: The company's profitability declines, possibly due to reduced revenue, increased costs, management errors, etc., leading to profits falling below market expectations.
l Valuation contraction: Due to profit decline or deteriorating market outlook, investor confidence in the company's future declines, leading to a drop in its valuation multiples (such as P/E ratio) and a decrease in stock price.
The entire logic is as follows: First, the company fails to meet the expected profit target or faces operational difficulties, leading to poor performance and profit decline. This will further worsen the market's future expectations, causing investor confidence to wane, unwilling to accept the currently overestimated P/E ratio, only willing to pay lower prices for the stock, thus leading to a decline in valuation multiples and further stock price drop.
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 the decline in profits, the market begins to doubt 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 Profit declines by 20%, meaning earnings per share (EPS) decrease from $5 to $4.
l P/E ratio decreased from 15 to 12.
l New stock price: $4 × 12 = $48
The stock price falls from $100 to $48, reflecting the dual effects of profit decline and valuation contraction.
This resonance effect often occurs in high-growth stocks, especially in many technology stocks, because investors are usually willing to give these companies' future growth a higher expectation. However, this expectation usually has a considerable subjective factor behind it, so the corresponding volatility is also large.
How is MSTR's high premium formed, and why does it become 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 switched its business from traditional software business to financing purchases of BTC, and of course, it does not rule out corresponding asset management revenue in the future. This means that this company’s profit comes from the capital gains of BTC appreciation purchased through equity dilution and bond issuance. As BTC appreciates, all investors' shareholder equity will increase accordingly, benefiting investors. In this regard, MSTR is no different from other BTC ETFs.
The difference lies in the leverage effect brought about by its financing capability, as MSTR investors' expectations of the company's future profit growth are derived from the leverage gains obtained from its financing capability growth. Considering that MSTR's total market value relative to its total BTC value is in a positive premium state, this means that MSTR's total market value is higher than its total BTC value. As long as it remains in this positive premium state, whether through equity financing or convertible bond financing, the funds obtained 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, total circulating shares X, and its total market value is Y. At this point, per-share equity would be $40 billion / X. If financing is done through the most unfavorable equity dilution, assuming the new share issuance ratio is a, this means total circulating shares become X * (a + 1). To complete financing at the current valuation, a total of a * Y billion dollars will be raised. If all these funds are converted into BTC, the BTC holding will change from $40 billion to $40 billion + a * Y billion, meaning per-share equity will be:
We will subtract it from the original per-share equity to calculate the impact of equity dilution on per-share equity growth as follows:
This means that when Y exceeds $40 billion, which is the value of its held BTC, it indicates the existence of a positive premium, completing financing to purchase BTC will consistently lead to an increase in per-share equity greater than 0. The larger the positive premium, the higher the per-share equity growth, and the two are linearly related. As for the impact of dilution ratio a, in the first quadrant, it shows an inverse relationship, indicating that the fewer 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 BTC holdings 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 gaining more pricing power over BTC. The continuous enhancement of pricing power will also strengthen investors' confidence in future growth even under high P/E ratios, allowing it to complete fundraising.
In summary, the secret of MicroStrategy's business model lies in the fact that BTC appreciation drives the company's profit growth, and a favorable BTC growth trend means a good trend in enterprise profit growth. Under the support of this 'Davis Double Play', MSTR's positive premium begins to amplify, so the market is speculating 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 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 the 'Davis Double Kill', and BTC entering a high volatility phase is the beginning of the entire domino effect.
Let us imagine that when the rise of BTC slows down and enters a volatile period, MicroStrategy's profits will inevitably begin to decline. Here I want to elaborate. I see some partners value their holding costs and unrealized gains very much. This is meaningless. The reason is that in MicroStrategy's business model, profit is 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 will the real profit level be confirmed by the market. During this period, investors can only estimate changes in financial conditions based on some external information. In other words, for most of the time, the stock price response lags behind the company's real earnings change. This lagging relationship will be corrected when each quarterly financial report is released. However, in MicroStrategy's business model, because both the holding scale and the price of BTC 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. Given this, the stock price already truly reflects all its profits, and there is no lag effect; therefore, focusing on holding costs is meaningless.
Bringing the topic back, let’s see how the 'Davis Double Kill' unfolds. When the growth of BTC slows down and enters a volatile phase, MicroStrategy's profits will continuously decline, even to zero. At this time, the fixed operating costs and financing costs will further shrink the company's profits, possibly leading to a loss. During this time, such volatility will constantly erode the market's confidence in the future development of BTC prices. This will transform into doubts about MicroStrategy’s financing capability, further impacting expectations for its profit growth. Under the resonance of these two factors, MSTR's positive premium will quickly converge. To maintain the validity of its business model, Michael Saylor must maintain the positive premium state. Therefore, selling BTC to regain funds to repurchase stock is a necessary operation, and this is the moment MicroStrategy begins to sell its first BTC.
Some partners may ask, why not just hold BTC and let the stock price fall naturally? My answer is no, to be more precise, it is not possible when BTC prices reverse; during volatility, it can be tolerated to some extent. The reason lies in MicroStrategy's current equity structure and what is optimal for Michael Saylor.
According to the current shareholding ratio of MicroStrategy, there are several top-tier consortiums, such as Jane Street and BlackRock. As the founder, Michael Saylor holds less than 10%. Of course, through a dual-class share structure, Michael Saylor has absolute voting rights, as he holds more Class B common stock, and the voting rights of Class B common stock are in a 10:1 relationship with Class A. Therefore, this company is still under Michael Saylor's strong control, but his equity share is not high.
This means that for Michael Saylor, the company's long-term value is far higher than the value of the BTC it holds, because if the company faces bankruptcy liquidation, it won't be able to obtain much BTC.
So what are the benefits of selling BTC during the volatile phase and repurchasing stocks to maintain the premium? The answer is also obvious. When there is a premium convergence, assuming Michael Saylor judges that MSTR's P/E ratio is undervalued due to panic, selling BTC to regain funds and repurchasing MSTR from the market is a lucrative operation. Therefore, at this point, the repurchase effect on reducing circulation and magnifying per-share equity will outweigh the effect of reducing per-share equity due to shrinking BTC reserves. When the panic ends and the stock price rebounds, per-share equity will become higher, benefiting subsequent developments. This effect is easier to understand in extreme cases when BTC trend reversals occur and MSTR experiences a negative premium.
Considering Michael Saylor's current holding volume, and when there is volatility or a downward cycle, liquidity is usually tightened. Therefore, when he starts to sell, the price of BTC will drop. The acceleration of the drop will further worsen investors' expectations of MicroStrategy's profit growth, leading to a further decrease in the premium rate, which may force him to sell BTC to repurchase MSTR, at which point the 'Davis Double Kill' begins.
Of course, another reason forcing it to sell BTC to maintain the stock price is that its behind-the-scenes investors are a group of powerful Deep State actors who cannot passively watch the stock price plummet without taking action, inevitably putting pressure on Michael Saylor to fulfill his responsibility for market value management. Furthermore, recent news indicates that with continuous equity dilution, Michael Saylor's voting power has fallen below 50%. However, I have not found specific sources for this news. But this trend seems unavoidable.
Does MicroStrategy's convertible bonds really have no risk before maturity?
After the above discussion, I believe I have fully articulated my logic. I would also like to discuss a topic here: 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 expand 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 could still be reflected in the stock price in advance.
The convertible bonds issued by MicroStrategy are essentially bonds with free call options added. At maturity, creditors can request MicroStrategy to redeem at the previously agreed conversion rate. However, there is also protection for MicroStrategy, as it can choose the redemption method actively, using cash, stock, or a combination of both. This is relatively flexible; if funds are sufficient, they can repay more in cash to avoid dilution of equity. If funds are tight, they can use more stock. Moreover, this convertible bond is unsecured, so the risk from debt repayment is not significant. Additionally, there is protection for MicroStrategy: if the premium exceeds 130%, MicroStrategy can also choose to redeem in cash at face value, which creates conditions for renegotiating loans.
Thus the bondholders will only have capital gains if the stock price is above the conversion price and below 130% of the conversion price. Otherwise, there will only be the principal plus low interest. Of course, after the reminder from Teacher Mindao, this bond's investors are mainly hedge funds used for Delta hedging, to earn volatility returns. Therefore, I thought carefully about the underlying logic.
Using convertible bonds for Delta hedging essentially involves purchasing MSTR convertible bonds while shorting an equivalent amount of MSTR stock to hedge against the risks brought by stock price fluctuations. Moreover, as subsequent price developments unfold, hedge funds need to continuously adjust positions for dynamic hedging. Dynamic hedging usually has the following two scenarios:
l When MSTR's stock price drops, 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, it is necessary to short more MSTR shares to match the new Delta value.
l 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, repurchasing part of the previously shorted MSTR shares to match the new Delta value is necessary to maintain the hedge of the portfolio.
Dynamic hedging needs to be frequently adjusted under the following circumstances:
l Significant volatility in the target stock price: Significant changes in Bitcoin prices lead to drastic fluctuations in MSTR stock prices.
l Changes in market conditions: Such as volatility, interest rates, or other external factors affecting the pricing model of convertible bonds.
l Hedge funds usually trigger operations based on the magnitude of Delta changes (e.g., every 0.01 change) to maintain precise hedging of the portfolio.
Let us illustrate a specific scenario. Suppose a hedge fund's initial position is as follows:
l Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).
l Short $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, so the stock position needs to be adjusted.
Calculate the number of stocks to be repurchased as (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 of the stock position.
Calculate the number of short stocks to increase as (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 shares to dynamically hedge Delta, further impacting MSTR's stock price negatively, which will consequently affect the positive premium and the entire business model. Therefore, the risk on the bond side will be reflected in the stock price in advance. Of course, during MSTR's upward trend, hedge funds will buy more MSTR, so it is also a double-edged sword.
