Author: @Web3_Mario
Summary: Last week we discussed the potential benefits of Lido from changes in the regulatory environment, hoping to help everyone seize this wave of 'Buy the rumor' trading opportunities. This week, a very interesting theme is the heat of MicroStrategy. Many predecessors have commented on the company's operating model. After digesting and studying it deeply, I have some of my own views that I would like 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 to purchase BTC, linking the appreciation of BTC with company profits, and obtaining financial leverage through innovative designs that combine traditional financial market financing channels, allowing the company to achieve profit growth beyond the appreciation of its BTC holdings. At the same time, as the holdings expand, the company gains some pricing power over BTC, further reinforcing 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 discounted, thereby affecting profit growth expectations. Unless new support can further push up the BTC price, the positive premium of MSTR relative to BTC holdings will quickly converge, which is known as the so-called 'Davis Double Kill.'
What is the Davis Double Play and Double Kill
Familiar friends should know that the author is committed to helping more non-financial professionals understand these dynamics, thus I will replay my own thought process. Therefore, I will first supplement some basic knowledge about what constitutes the 'Davis Double Play' and 'Double Kill.'
The so-called 'Davis Double Play' was proposed by investment master Clifford Davis and is typically used to describe the phenomenon of a company's stock price soaring due to two factors in a favorable economic environment. These two factors are:
Company profit growth: the company achieves strong profit growth, or optimizations in its business model, management, etc., lead to increased profits.
Valuation expansion: due to the market being more optimistic about the company's prospects, investors are willing to pay a higher price, thus driving the stock's valuation upward. 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 exceeds expectations for profits, with both revenue and profits increasing. For example, strong product sales, expanded market share, or successful cost control will directly lead to profit growth for the company. This growth will also enhance the market's confidence in the company's future prospects, leading investors to accept a higher price-to-earnings ratio (P/E) and pay a higher price for the stock, causing the valuation to begin expanding. This linear and exponential combined positive feedback effect often leads to accelerated increases in stock prices, known as the 'Davis Double Play.'
To illustrate this process with an example, 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 company's earnings growth and changes in market sentiment, investors are willing to pay an 18 times price-to-earnings ratio, then even if the earnings growth rate remains unchanged, the increase in valuation will also drive the stock price to rise significantly, for example:
Current stock price: $100
Earnings increase by 30%, meaning earnings per share (EPS) rise 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 profit growth and valuation improvement.
The 'Davis Double Kill' is the opposite, usually used to describe the rapid decline of stock prices under the joint 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 errors, etc., resulting in profits below market expectations.
Valuation contraction: due to profit decline or deteriorating market outlook, investors' confidence in the company's future decreases, leading to a decline in its valuation multiples (such as price-to-earnings ratio) and a drop in stock prices.
The whole logic is as follows: first, the company fails to achieve the expected profit target or faces operational difficulties, leading to poor performance and declining profits. This further worsens the market's expectations for its future prospects, causing investors to lack confidence and unwilling to accept the currently high price-to-earnings ratio, only willing to pay a lower price for the stock, leading to a decline in valuation multiples and further drop in stock prices.
To illustrate this process with an example, suppose a company's current price-to-earnings ratio is 15 times, and its future earnings are expected to decrease by 20%. Due to the earnings decline, the market begins to have doubts about the company's prospects, and investors start to lower its price-to-earnings ratio. For example, reducing the price-to-earnings ratio from 15 to 12. The stock price may therefore drop significantly, for example:
Current stock price: $100
Earnings decrease by 20%, meaning earnings per share (EPS) drop from $5 to $4.
Price-to-earnings ratio drops from 15 to 12.
New stock price: $4 × 12 = $48
The stock price drops from $100 to $48, reflecting the dual effects of earnings decline and valuation contraction.
This resonance effect usually occurs in high-growth stocks, especially in many technology stocks, because investors are often willing to give these companies' future growth a higher expectation. However, this expectation is usually supported by a significant subjective factor, so the corresponding volatility is also large.
How the high premium of MSTR is created, 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 switched its business from traditional software to financing for buying BTC, of course, not excluding future corresponding asset management revenue. This means that the company's profit comes from the capital gains of BTC purchased with funds obtained through equity dilution and bond issuance. With the appreciation of BTC, the shareholders' equity of all investors will correspondingly increase, and investors will benefit accordingly. In this regard, MSTR is no different from other BTC ETFs.
What makes a difference is the leverage effect brought by its financing ability, because MSTR investors' expectations for the company's future profit growth are derived from the leverage gains obtained from its financing ability growth. Considering that MSTR's total market value relative to its total BTC value is in a positive premium state, meaning MSTR's total market value exceeds its total BTC value. As long as it is in this positive premium state, whether equity financing or convertible bond financing, along with the funds obtained for purchasing BTC, will further increase per-share equity. This enables MSTR to have a profit growth capability different from that of BTC ETFs.
For example, suppose MSTR currently holds BTC worth $40 billion, with total circulating shares X, its total market value is Y. At this point, per-share equity is $40 billion / X. Assuming the most unfavorable scenario of equity dilution, if 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 will be raised. If all these funds are converted into BTC, the holdings will change from $40 billion to $40 billion + a * Y billion, meaning per-share equity will become:
We will subtract it from the original per-share equity to calculate the impact of diluted shares on per-share equity growth as follows:
This means that when Y exceeds $40 billion, meaning the value of its held BTC, it indicates the existence of a positive premium, and completing financing to purchase BTC will bring per-share equity growth that is always greater than 0. The larger the positive premium, the higher the per-share equity growth. The two are linearly related. As for the impact of dilution ratio 'a', it presents an inverse characteristic in the first quadrant, meaning that the less shares are issued, the greater the equity growth.
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 gaining more pricing power over BTC. The continuous enhancement of pricing power will also strengthen investors' confidence in future growth even at high price-to-earnings ratios, enabling them to complete fundraising.
In summary, the secret of MicroStrategy's business model lies in the appreciation of BTC driving the company's profit increase, and a favorable growth trend in BTC implies a favorable growth trend in corporate profits. Under the support of this '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 to complete 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 the core lies in how this business model significantly increases the volatility of BTC prices, acting as an amplifier of volatility. The reason lies in the 'Davis Double Kill', and when BTC enters a high position of turbulence, it marks the beginning of the entire domino effect.
Let's imagine when the BTC growth slows down and enters a volatile period, MicroStrategy's profits will inevitably begin to decline. Here, I want to elaborate, I have seen some partners pay great attention to their holding costs and floating profit scale. 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 that truly cause stock price fluctuations are financial reports. Only when quarterly financial reports are published will the real profit level 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, the stock price reaction lags behind the company's real revenue changes, and this lagging relationship will be corrected when each quarterly financial report is published. However, in MicroStrategy's business model, because its holding scale and the price of BTC are both 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. Since this is the case, the stock price has already truly reflected all its profits, and there is no lag effect. Therefore, paying attention to its holding costs is meaningless.
Returning to the topic, let’s look at how the 'Davis Double Kill' unfolds. When the growth of BTC slows down and enters a volatile phase, MicroStrategy's profits will continuously decline or even go to zero. At this time, fixed operating costs and financing costs will further shrink the company's profits, potentially leading to a loss. During this time, this turbulence will gradually erode the market's confidence in the subsequent development of BTC prices. This will translate into doubts about MicroStrategy's financing ability, further impacting expectations for its profit growth. In this resonance of the two, MSTR's positive premium will quickly converge. To maintain the establishment of its business model, Michael Saylor must maintain the state of positive premium. Therefore, selling BTC to recoup funds to repurchase stock becomes a necessary operation, marking the moment when MicroStrategy begins to sell its first BTC.
Some partners may ask, can't we just hold BTC and let the stock price fall naturally? My answer is no, more precisely, it cannot be done when the BTC price reverses, but it can be tolerated during turbulence, because of MicroStrategy's current share structure and what constitutes the optimal solution for Michael Saylor.
According to the current shareholding ratio of MicroStrategy, there are some top-tier consortiums, such as Jane Street and BlackRock, while Michael Saylor, as the founder, holds less than 10%. Of course, through the design of dual-class shares, Michael Saylor's voting rights have an absolute advantage, as he holds more Class B common stock, where the voting rights of Class B are 10:1 compared to Class A. So the company is still under Michael Saylor's strong control, but his shareholding proportion 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 if the company faces bankruptcy liquidation, the BTC it can obtain would not be much.
So what are the benefits of selling BTC during the volatile phase and repurchasing stock to maintain the premium? The answer is obvious. When the premium converges, if Michael Saylor judges that MSTR's price-to-earnings ratio is undervalued due to panic, then selling BTC to get funds back and repurchasing MSTR from the market is a worthwhile operation. Therefore, at this time, the effect of repurchasing on reducing the circulation will amplify the per-share equity effect more than the effect of reducing per-share equity due to a decrease in BTC reserves. When the panic ends and the stock price rebounds, per-share equity will become higher, benefiting future development. This effect is easier to understand in extreme cases of BTC trend reversal when MSTR is at a negative premium.
Considering the current holding volume of Michael Saylor, and during periods of turbulence or downturn, liquidity is usually tightened. Therefore, when he starts to sell, the price of BTC will drop at an accelerated rate. The accelerated drop will further worsen investors' expectations for MicroStrategy's profit growth, leading to a further decrease in the premium rate, which may force him to sell BTC to repurchase MSTR, initiating the 'Davis Double Kill.'
Of course, another reason that forces it to sell BTC to maintain its stock price is that the investors behind it are a group of powerful Deep State players who cannot remain indifferent while watching the stock price plummet, inevitably putting pressure on Michael Saylor to take responsibility for managing his market value. Moreover, recent information shows that with continuous equity dilution, Michael Saylor's voting rights have fallen below 50%. Although I have not found specific sources for this news, this trend seems unavoidable.
Does MicroStrategy's convertible bond really have no risk before maturity
After the above discussion, I think I have fully articulated my logic. I would also like 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 will not expand on that here. Indeed, its debt duration is quite long. Before the maturity date, there is indeed no repayment risk. 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 layered with free call options. Upon maturity, creditors can request MicroStrategy to redeem stocks at the previously agreed conversion rate. However, there is also protection for MicroStrategy. MicroStrategy can choose the redemption method, using cash, stock, or a combination of both, which is relatively flexible. If funds are abundant, it can repay more cash to avoid dilution of equity; if funds are tight, it can issue more stock. Moreover, this convertible bond is unsecured, so the risks associated with debt repayment are not significant. Additionally, there is protection for MicroStrategy: if the premium rate exceeds 130%, MicroStrategy can also choose to redeem at face value in cash, which provides conditions for refinancing negotiations.
Therefore, the creditor of this bond will only have capital gains when the stock price is above the conversion price and below 130% of the conversion price. Otherwise, there is only the principal plus low interest. Of course, after being reminded by Mr. Mindao, the investors in this bond are mainly hedge funds that use it for Delta hedging to earn volatility profits. Thus, I thought carefully about the underlying logic.
Using convertible bonds for Delta hedging mainly involves purchasing MSTR convertible bonds while short selling an equivalent amount of MSTR stock to hedge against risks from stock price fluctuations. Moreover, as subsequent price developments occur, hedge funds need to continuously adjust 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 bond 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 conversion rights of the bond become more valuable (closer to 'in the money'). At this point, repurchasing some of the previously shorted MSTR stock is needed to match the new Delta value, thereby maintaining the hedging of the portfolio.
Dynamic hedging requires frequent adjustments under the following circumstances:
Significant fluctuations in the underlying stock price: for example, large changes in Bitcoin prices lead to sharp fluctuations in MSTR stock prices.
Changes in market conditions: such as volatility, interest rates, or other external factors affecting the pricing model of convertible bonds.
Hedge funds typically trigger operations based on the magnitude of Delta changes (for example, every change of 0.01), maintaining precise hedging of the portfolio.
Let's present a specific scenario to illustrate. Suppose an initial position of a hedge fund 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, requiring an adjustment to 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 drops from $100 to $95, the new Delta value of the convertible bond becomes 0.55, requiring an adjustment to the stock position. The calculation for the additional short stock needed is (0.6−0.55)×10 million = 500,000. The specific operation is to short sell $500,000 worth of stock.
This means that when the MSTR price falls, the hedge funds behind the convertible bond will need to sell more MSTR stock to dynamically hedge Delta, further impacting the MSTR stock price, which will negatively affect the positive premium and thus affect the entire business model. Therefore, the risk on the bond side will be reflected in advance through the stock price. Of course, during MSTR's upward trend, hedge funds will buy more MSTR, so it is also a double-edged sword.
