Last week we discussed the potential benefits to 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 topic is the heat surrounding MicroStrategy, with many predecessors commenting on the company's operating model. After digesting and researching it further, I have some of my own views that I would like to share with everyone. I believe the reason for MicroStrategy's stock price increase lies in the 'Davis Double Hit'. Through the business design of financing to purchase BTC, it binds BTC appreciation to company profits and obtains financial leverage through innovative designs that combine traditional financial market financing channels, enabling the company to surpass the profit growth brought about by its BTC appreciation. At the same time, as the holdings increase, the company gains a certain pricing power over BTC, further strengthening this profit growth expectation. However, the risk lies in this: when the BTC market experiences volatility or reversal risks, profit growth from BTC will stall, and under the influence of the company's operating expenses and debt pressure, MicroStrategy's financing ability will be greatly reduced, further impacting profit growth expectations. Unless there is new support to further push up BTC prices, otherwise MSTR's stock price relative to its BTC holdings' positive premium will quickly converge, and this process is what is referred to as the 'Davis Double Kill'.
What are 'Davis Double Hit' and 'Double Kill'?
Friends who are familiar with me should know that I am committed to helping more friends outside the financial profession understand these dynamics, so I will replay my own thinking logic. Therefore, I will first supplement some basic knowledge about what 'Davis Double Hit' and 'Double Kill' are.
The so-called 'Davis Double Play' was proposed by investment master Clifford Davis, usually used to describe the phenomenon of a sharp rise in stock prices caused by two factors under a favorable economic environment. These two factors are:
Company profit growth: The company has achieved strong profit growth, or its business model, management, and other aspects have been optimized, leading to an increase in profits.
Valuation expansion: As the market is more optimistic about the company's prospects, investors are willing to pay a higher price for it, thus driving up the stock valuation. In other words, the 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 growing. 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 market confidence in the company's future prospects, causing investors to accept a higher price-to-earnings ratio (P/E) and pay a higher price for the stock, leading to valuation expansion. This linear and exponential combined positive feedback effect usually results in accelerated increases in stock prices, known as the 'Davis Double Play.'
To illustrate this process, suppose a company's current price-to-earnings ratio is 15 times, and it is expected that its future profits will grow by 30%. If due to the company's profit growth and changes in market sentiment, investors are willing to pay a price-to-earnings ratio of 18 times, then even if the profit growth rate remains unchanged, the valuation uplift will push the stock price up significantly, for example:
Current stock price: $100
Earnings growth of 30% means earnings per share (EPS) increases from $5 to $6.5.
The 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 uplift.
The '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 decreases, possibly due to reduced revenue, increased costs, management errors, and other factors, leading to profits lower than market expectations.
Valuation contraction: Due to profit decline or worsening market prospects, investors' confidence in the company's future decreases, leading to a decline in its valuation multiples (such as price-to-earnings ratio) and stock price.
The entire logic is as follows: first, the company fails to meet the expected profit targets or faces operational difficulties, leading to poor performance and declining profits. This will further worsen the market's future expectations for it, causing investors to lack confidence and unwilling to accept the currently overvalued price-to-earnings ratio, only willing to pay a lower price for the stock, thus leading to a decrease in valuation multiples and further decline in stock price.
To illustrate this process with an example, suppose a company's current price-to-earnings ratio is 15 times, and it is expected that its future profits will decline by 20%. Due to the profit decline, the market begins to have doubts about the company's prospects, and investors start to lower its price-to-earnings ratio. For example, the price-to-earnings ratio decreases from 15 to 12. The stock price may therefore drop significantly, for example:
Current stock price: $100
Earnings decline of 20% means earnings per share (EPS) decrease 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 profit decline and valuation contraction.
This resonance effect usually occurs in high-growth stocks, especially in many technology stocks, because investors are often willing to pay a higher expected value for these companies' future growth. However, this expectation is usually supported by a relatively large subjective factor, so the corresponding volatility is also quite large.
How is MSTR's high premium created, and why has it become the core of its business model?
After supplementing this background knowledge, I think everyone should be able to roughly understand how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy has shifted its business from traditional software to financing and purchasing BTC, and of course, it does not rule out future corresponding asset management revenues. This means that the company's profit comes from the capital gains on BTC appreciation purchased with funds obtained through equity dilution and debt issuance. As BTC appreciates, all investors' shareholder equity will increase accordingly, and investors will benefit. In this regard, MSTR is no different from other BTC ETFs.
The difference arises from the leverage effect brought about 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. Considering that MSTR's total market value relative to its BTC holdings is in a positive premium state, this means that MSTR's total market value is higher than the total value of the BTC it holds. As long as it is in this positive premium state, whether it is equity financing or its convertible bond financing, along with the funds obtained to purchase BTC, will further increase per share equity. This gives MSTR the ability to achieve profit growth that is different from BTC ETFs.
To illustrate, suppose the current BTC held by MSTR is 40 billion dollars, total outstanding shares X, and its total market value is Y. At this point, the per share equity is 40 billion / X. If financing is done at the most unfavorable share dilution, suppose the new share issuance ratio is a, this means that the total outstanding shares become X * (a + 1). To complete financing at the current valuation, a total of a * Y billion dollars is raised. If all these funds are converted into BTC, then the BTC holdings become 40 billion + a * Y billion, which means the per share equity becomes:
We will subtract it from the original per share equity to calculate the impact 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 the BTC it holds, it means there is a positive premium, and the increase in per share equity from financing to buy BTC is always greater than 0, and the greater the positive premium, the higher the per share equity growth, both of which have a linear relationship. As for the impact of the dilution ratio a, it presents an inverse proportion feature in the first quadrant, which means that the fewer shares issued, the greater the increase in equity.
So for Michael Saylor, the premium of MSTR's market capitalization relative to the value of its BTC holdings is the core factor for its business model to be established. Therefore, 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 strengthening of pricing power will also enhance investors' confidence in future growth in the case of high price-to-earnings ratios, enabling them to complete fundraising.
To summarize, the secret of MicroStrategy's business model lies in the fact that BTC appreciation drives the company's profits up, and a positive growth trend in BTC indicates a positive growth trend in corporate profits. Supported by this 'Davis Double Play', MSTR's positive premium begins to amplify, so the market is betting on how high of 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 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 the period when BTC enters a high volatility phase is the stage when the entire domino effect begins.
Let's imagine that when the increase of BTC slows down and enters a volatile period, MicroStrategy's profits will inevitably start to decline. Here I want to elaborate on the fact that I see some friends placing a lot of emphasis on their holding costs and 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 earnings reports. Only when quarterly earnings reports are published will the true profit level be confirmed by the market. In the meantime, investors can only estimate changes in financial situations based on some external information. This means that most of the time, stock price reactions lag behind the company's actual revenue changes. This lagging relationship will be corrected when quarterly earnings reports are published. However, in MicroStrategy's business model, as both its holding scale and BTC prices are publicly available 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. Therefore, the stock price already accurately 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 the 'Davis Double Kill' unfolds. When BTC's growth slows down and enters a volatile stage, MicroStrategy's profits will continuously decrease, even to zero. At this time, fixed operating costs and financing costs will further shrink the company's profits and could even lead to losses. During this time, this volatility will continuously erode market confidence in the subsequent price development of BTC. This will translate into doubts about MicroStrategy’s financing ability, further impacting expectations for its profit growth. Under the resonance of these two factors, MSTR's positive premium will rapidly converge. In order to maintain the validity of its business model, Michael Saylor must maintain the state of positive premium. Therefore, selling BTC to return funds to repurchase stock is a necessary operation, and this is when MicroStrategy begins selling its first BTC.
Some friends may ask, why not just hold BTC and let the stock price naturally drop? My answer is no, more precisely, it is not feasible when the BTC price reverses. However, it can be tolerated to some extent during volatility because of MicroStrategy's current equity 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, and as the founder, Michael Saylor holds less than 10%. Of course, through the dual-class share design, Michael Saylor's voting power has absolute advantage, as he holds more B-class common stock, and the voting rights of B-class common stock are in a 10:1 relationship with A-class. So this company is still under strong control by 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 the BTC it holds, because if the company faces bankruptcy liquidation, it would not gain much BTC.
So what are the benefits of selling BTC to repurchase stock during a volatile phase? 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 to return funds and repurchasing MSTR from the market is a cost-effective operation. Therefore, at this time, the effect of reducing the circulation on per share equity will outweigh the effect of reducing per share equity due to the decrease in BTC reserves. Once the panic ends and the stock price rebounds, per share equity will become higher, benefiting subsequent development. This effect is easier to understand in extreme cases of BTC trend reversal when MSTR exhibits a negative premium.
Considering Michael Saylor's current holdings and the fact that liquidity usually tightens during periods of volatility or downturns, when he starts to sell, the price of BTC will fall faster. The acceleration of the decline will further worsen investors' expectations for MicroStrategy's profit growth, and the premium rate will further decline, which may force him to sell BTC to repurchase MSTR. At this time, the 'Davis Double Kill' begins.
Of course, another reason that forces it to sell BTC to maintain the stock price is that the investors behind it are a group of influential Deep State individuals who cannot passively watch the stock price drop to zero without taking action, which will undoubtedly put pressure on Michael Saylor, forcing him to take responsibility for managing its market value. Moreover, I found in recent information that with continuous equity dilution, Michael Saylor's voting power has dropped below 50%. However, I haven't found the specific news source. But this trend seems to be unavoidable.
Does MicroStrategy's convertible bond really have no risk before maturity?
After the discussion above, I think I have fully articulated my logic. I would also like to discuss a topic: whether MicroStrategy has no debt risk in the short term. Some predecessors have introduced the nature of MicroStrategy's convertible bonds, and I will not discuss it here. Indeed, its debt duration is quite long. Before the maturity date arrives, there is indeed no repayment risk. But my point is that its debt risk may still feedback in advance through the stock price.
MicroStrategy's issued convertible bonds are essentially bonds layered with free call options. Upon maturity, creditors can require MicroStrategy to redeem for shares equivalent to the previously agreed conversion rate. However, there is also protection for MicroStrategy, as it can proactively choose the redemption method, using cash, stock, or a combination of both. This allows for some flexibility; if funds are ample, it can repay more in cash to avoid equity dilution. If funds are tight, it can issue more stock. Moreover, this convertible bond is unsecured, so the risk from repayment is not great. Additionally, there is protection for MicroStrategy, as if the premium rate exceeds 130%, MicroStrategy can also choose to redeem directly in cash at the original value, which creates conditions for refinancing negotiations.
Thus, the bondholders of this debt will only have capital gains when the stock price is above the conversion price and below 130% of the conversion price. Otherwise, there will only be principal plus low interest. Of course, after the reminder from Teacher Mindao, the investors in this bond are mainly hedge funds used for Delta hedging to earn volatility profits. Therefore, I have thought more about the logic behind it.
Delta hedging through convertible bonds specifically involves purchasing MSTR convertible bonds while shorting an equal amount of MSTR stock to hedge against risks brought about by stock price fluctuations. Moreover, along with subsequent price developments, hedge funds need to continuously adjust their positions for dynamic hedging. Dynamic hedging usually has the following two scenarios:
When MSTR's stock price drops, the convertible bond's Delta value decreases because the bond's conversion right becomes less valuable (closer to 'out of the money'). Therefore, more MSTR stock needs to be shorted to match the new Delta value.
When MSTR's stock price rises, the convertible bond's Delta value increases because the bond's conversion right becomes more valuable (closer to 'in the money'). Therefore, part of the previously shorted MSTR stock needs to be bought back to match the new Delta value, thus maintaining the hedging of the portfolio.
Dynamic hedging needs to be adjusted frequently under the following circumstances:
Significant fluctuations in the underlying stock price: such as large changes in Bitcoin prices leading to drastic fluctuations in MSTR stock prices.
Changes in market conditions: such as changes in 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 (e.g., 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 convertible bonds of MSTR worth 10 million dollars (Delta = 0.6).
Shorting MSTR stock worth 6 million dollars.
When the stock price rises from $100 to $110, the convertible bond Delta value becomes 0.65, and the stock position needs to be adjusted. The calculation shows that the number of stocks to be repurchased is (0.65 - 0.6) × 10 million = 500,000. The specific operation is to buy back 500,000 dollars' worth of stock.
When the stock price falls from $100 to $95, the new Delta value of the convertible bond becomes 0.55, and the stock position needs to be adjusted. The calculation shows that the additional short stock needed is (0.6 - 0.55) × 10 million = 500,000. The specific operation is to short 500,000 dollars' worth of stock.
This means that when the MSTR price drops, the hedge funds behind its convertible bonds will short more MSTR stock to dynamically hedge Delta, further impacting MSTR's stock price, which will negatively affect the premium and thus impact the entire business model. Therefore, the risk on the bond side will feedback through the stock price in advance. Of course, in the upward trend of MSTR, hedge funds will buy more MSTR, so it is also a double-edged sword.
