Author:@Web3_Mario
Summary: Last week we discussed the potential for Lido to benefit from changes in the regulatory environment, hoping to help everyone grasp this wave of "Buy the rumor" trading opportunities. This week, there is a very interesting topic, which is the heat of MicroStrategy. Many seniors have commented on the operating model of this company. After digesting and delving into it, I have some of my own views, which I hope to share with you. I think the reason for the rise in MicroStrategy's stock price is the "Davis Double Play", through the business design of financing to purchase BTC, binding BTC's appreciation and the company's profitability, and obtaining financial leverage through the innovative design of combining traditional financial market financing channels, the company has the ability to grow its profits beyond the appreciation of the BTC it holds, and as the holding scale expands, the company has a certain pricing power over BTC, further strengthening this profit growth expectation. However, the risk also lies in this, when the BTC market experiences volatility or reversal risk, the profit growth from BTC will stagnate, and at the same time affected by the company's operating expenses and debt pressure, MicroStrategy's financing capacity will be greatly discounted, which will affect the profit growth expectation, at which time, unless there is new support to further push up the BTC price, the premium of MSTR stock price relative to its BTC holdings will converge rapidly, and this process is also the so-called "Davis Double Kill".
What is Davis Double Play and Double Kill
Familiar friends should know that the author is committed to helping more non-financial professionals understand these dynamics, so I will replay my own thinking logic. Therefore, let's first supplement some basic knowledge, what is "Davis Double Play" and "Double Kill".
The so-called "Davis Double Play" (Davis Double Play) was proposed by investment master Clifford Davis, and is usually used to describe the phenomenon of a significant increase in a company's stock price due to two factors in a good economic environment. These two factors are:
l Profit growth: The company has achieved strong profit growth, or its business model, management team and other aspects have been optimized, leading to an increase in 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 for it, thereby driving up the stock's valuation. That is, the stock's price-to-earnings ratio (P/E Ratio) and other valuation multiples expand.
The specific logic that drives the "Davis Double Play" is as follows. First, the company's performance exceeds expectations, with both revenue and profits growing. For example, good product sales, market share expansion or successful cost control, these will directly lead to the company's profit growth. And this growth will also strengthen the market's confidence in the company's future prospects, causing investors to be willing to accept a higher P/E ratio, paying a higher price for the stock, and the valuation begins to expand. This linear and exponential combination of positive feedback effects often leads to an accelerated rise in stock prices, which is the so-called "Davis Double Play".
To illustrate this process, let's assume that a company's current P/E ratio is 15 times, and its future earnings are expected to grow by 30%. If, due to the company's profit growth and the change in market sentiment, investors are willing to pay 18 times the P/E ratio, then even if the growth rate remains unchanged, the increase in valuation will drive a significant increase in the stock price, for example:
l Current stock price: $100
l Earnings growth of 30%, meaning earnings per share (EPS) increase from $5 to $6.5.
l P/E ratio increases from 15 to 18.
l New stock price: $6.5 × 18 = $117
The stock price has risen from $100 to $117, reflecting the dual effect of profit growth and valuation expansion.
On the other hand, "Davis Double Kill" is the opposite, usually used to describe the rapid decline in stock prices under the joint action of two negative factors. These two negative factors are:
l Profit decline: The company's profitability declines, which may be due to factors such as reduced revenue, increased costs, or management mistakes, leading to profits lower than market expectations.
l Valuation contraction: Due to the decline in profits or the deterioration of the market outlook, investors' confidence in the company's future prospects has declined, leading to a decline in its valuation multiples (such as the P/E ratio), and the stock price has fallen.
The overall logic is as follows. First, the company fails to meet its expected profit targets, or faces operational difficulties, resulting in poor performance and declining profits. This will further worsen the market's expectations for its future, and investors' confidence is insufficient, unwilling to accept the currently high P/E ratio, only willing to pay a lower price for the stock, leading to a decline in the valuation multiple and a further decline in the stock price.
Similarly, let's use an example to illustrate this process. Assume that a company's current P/E ratio is 15 times, and its future earnings are expected to decline by 20%. Due to the decline in earnings, the market begins to doubt the company's prospects, and investors begin to lower its P/E ratio. For example, reducing the P/E ratio from 15 to 12. The stock price may plummet as a result, for example:
l Current stock price: $100
l Earnings decline by 20%, meaning earnings per share (EPS) decrease from $5 to $4.
l P/E ratio decreases from 15 to 12.
l New stock price: $4 × 12 = $48
The stock price has fallen from $100 to $48, reflecting the dual effect 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 a higher expected valuation for their future business growth, but this expectation is often supported by a lot of subjective factors, so the corresponding volatility is also very large.
How is MSTR's high premium created, and why does 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 switched its business from the traditional software business to financing the purchase of BTC, although it does not rule out having corresponding asset management revenue in the future. This means that this company's profitability comes from the capital gains on the BTC it has purchased through equity dilution and debt financing. With the appreciation of BTC, all investors' shareholder equity will correspondingly increase, and investors will benefit from this, in this respect MSTR is no different from other BTC ETFs.
The difference arises from its financing capacity, which brings a leverage effect, because MSTR investors' expectation of the company's future profit growth comes from the leverage gains obtained through its financing capacity, considering that MSTR's total market capitalization is in a positive premium state relative to the total value of the BTC it holds, that is, MSTR's total market capitalization is higher than the total value of the BTC it holds. As long as it is in this positive premium state, regardless of equity financing and its convertible bond financing, the funds obtained will be used to purchase more BTC, which will further increase the equity per share. This gives MSTR a profit growth capability different from BTC ETFs.
To illustrate with an example, assume that MSTR currently holds $40 billion worth of BTC, with a total outstanding shares of X, and a total market capitalization of Y. Then the current equity per share is $40 billion / X. In the most unfavorable case of equity dilution financing, assume the issuance of new shares is a proportion of a, this means that the total outstanding shares will become X*(a+1), and by completing the financing at the current valuation, a total of a * Y billion dollars will be raised. By converting all of these funds into BTC, the BTC holdings will change from $40 billion to $40 billion + a * Y billion, meaning that the equity per share will become:
We will subtract the original equity per share to calculate the growth in equity per share due to the dilution of shares, as follows:
This means that when Y is greater than 400 billion, which is the value of the BTC it holds, that is, when there is a positive premium, the increase in equity per share brought about by the financing to buy BTC will always be greater than 0, and the greater the positive premium, the higher the increase in equity per share, the two being in a linear relationship, and as for the impact of the dilution ratio a, it presents an inverse proportional characteristic in the first quadrant, which means that the less the shares are issued, the higher the increase in equity.
So for Michael Saylor, the positive premium between MSTR's market value and the value of the BTC it holds is the core factor in the viability of his business model, so his optimal choice is how to maintain this premium while constantly raising funds and increasing his market share to gain more pricing power over BTC. And the continuous strengthening of pricing power will also strengthen investors' confidence in future growth even in the case of a high P/E ratio, enabling them to complete fundraising.
In summary, the secret of MicroStrategy's business model lies in the fact that the appreciation of BTC drives the increase in the company's profits, and the positive trend of BTC growth means that the trend of the company's profit growth is also positive, and with the support of this "Davis double kill", the positive premium of MSTR begins to expand, so the market is betting on how high a positive premium MicroStrategy can achieve in subsequent financing.
What are the risks that MicroStrategy brings to the industry
Next, let's talk about the risks that MicroStrategy brings to the industry. I believe that the core is that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of volatility. The reason is the "Davis double kill", and the entry of BTC into a high-volatility oscillation period is the beginning of the entire domino effect.
Let's imagine that when the growth of BTC slows down and enters a oscillation period, the profitability of MicroStrategy will inevitably start to decline. Here I want to explain that I see some partners attaching great importance to its holding cost and the scale of its floating profits. This is meaningless, because in MicroStrategy's business model, the profit is transparent and equivalent to real-time settlement. In the traditional stock market, we know that the factors that really cause stock price fluctuations are financial reports, and it is only when the quarterly financial reports are released that the market will confirm the true profit level. In the meantime, investors can only estimate the changes in the financial situation based on some external information. That is to say, most of the time, the stock price reaction lags behind the real changes in the company's profitability, and this lag relationship will be corrected when the quarterly financial reports are released. However, in MicroStrategy's business model, since its holding scale and BTC price are public information, investors can understand its real profitability in real time, and there is no lag effect, because the equity per share changes dynamically with it, equivalent to real-time settlement of profits. Since this is the case, the stock price has already truly reflected all its profits, and there is no lag effect, so it is meaningless to pay attention to its holding cost.
Bringing the topic back, let's look at how the "Davis double kill" unfolds. When the growth of BTC slows down and enters a oscillation phase, MicroStrategy's profits will continue to decline, even to zero. At this time, the fixed operating costs and financing costs will further shrink the company's profits, and even put it in a loss state. And at this time, this oscillation will constantly erode the market's confidence in the future development of BTC prices. And this will be translated into doubts about MicroStrategy's financing capabilities, further undermining expectations of its profit growth, and under the resonance of these two, the positive premium of MSTR will converge rapidly. And in order to maintain the viability of its business model, Michael Saylor must maintain the state of positive premium. So selling BTC to buy back shares is a necessary operation, and this is the moment when MicroStrategy starts to sell its first BTC.
Some partners may ask, why not just hold the BTC and let the stock price fall naturally. My answer is that it is not possible, or more precisely, it is not possible when the BTC price reverses, although it is possible to tolerate the oscillation to some extent, because of MicroStrategy's current shareholding structure and what is the optimal solution for Michael Saylor.
According to the current shareholding structure of MicroStrategy, there are many top-tier financial groups, such as Jane Street and BlackRock, while the founder Michael Saylor owns less than 10%. Of course, through the design of dual-class shares, Michael Saylor has absolute voting power, as he holds more Class B common shares, which have a 10:1 voting ratio to Class A. So 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 long-term value of the company is far higher than the value of the BTC he holds, because even if the company faces bankruptcy and liquidation, he would not get much BTC.
So what are the benefits of selling BTC and buying back shares to maintain the premium during the oscillation phase? The answer is also obvious. When the premium converges, if Michael Saylor judges that MSTR's P/E ratio is undervalued due to panic, then selling BTC to raise funds and repurchasing MSTR from the market is a profitable move. Therefore, the effect of reducing the float and amplifying the equity per share at this time will be greater than the effect of reducing the BTC reserve and shrinking the equity per share. When the panic is over and the stock price rebounds, the equity per share will become higher, which is beneficial for subsequent development. This effect is easier to understand in the extreme case where BTC trends reverse and MSTR appears at a negative premium.
Considering Michael Saylor's current holdings, and the fact that liquidity is usually tightened when there is oscillation or downward cycles, when he starts to sell, the price of BTC will accelerate its decline. And the accelerated decline will further worsen investors' expectations of MicroStrategy's profit growth, and the premium rate will further decline, which will force it to sell BTC to buy back MSTR, and then the "Davis double kill" begins.
Of course, there is another reason that forces it to sell BTC to maintain the stock price, which is that the investors behind it are a group of powerful Deep State, who cannot sit idly by and watch the stock price go to zero, and must put pressure on Michael Saylor to make him take responsibility for managing the market value. And recent news shows that with the continuous dilution of shares, Michael Saylor's voting rights have fallen below 50%, although I haven't found the specific source of this information. But this trend seems to be inevitable.
Is MicroStrategy's convertible bond really risk-free before maturity
After the above discussion, I think I have fully explained my logic. I would also like to discuss another 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 go into that here. Indeed, its debt duration is quite long. There is no repayment risk before the maturity date. But my view is that its debt risk may be reflected in advance through the stock price.
The convertible bonds issued by MicroStrategy are essentially bonds with a free call option embedded, and at maturity, the bondholders can request MicroStrategy to redeem them at the previously agreed conversion ratio in the form of shares. But there is also protection for MicroStrategy, that is, MicroStrategy can actively choose the redemption method, using cash, shares or a combination of the two, which is relatively flexible. If the funds are sufficient, they can repay more cash to avoid dilution of equity, and if the funds are insufficient, they can add more shares. Moreover, this convertible bond is unsecured, so the risk of repayment is not great. And there is also a protection for MicroStrategy, that is, if the premium rate exceeds 130%, MicroStrategy can also choose to redeem it directly in cash at par value, which creates conditions for refinancing negotiations.
So for the bondholders of this bond, they can only have capital gains when the stock price is higher than the conversion price, but lower than 130% of the conversion price, otherwise they can only get the principal plus low interest. Of course, as reminded by Mindao, the main investors of this bond are hedge funds using it for Delta hedging to earn volatility returns. So I have thought about the logic behind it in more detail.
The specific operation of Delta hedging through convertible bonds is mainly to buy the MSTR convertible bonds and short an equal amount of MSTR stocks to hedge the risk of stock price fluctuations. And with the subsequent price development, the hedge funds need to constantly adjust their positions for dynamic hedging. And there are usually two scenarios for dynamic hedging: 'TRON' is not translated. 'BTC' is not translated. 'CRO' is not translated. 'HT' is not translated. 'AR' is not translated. 'PLA' is not translated. 'RON' is not translated. 'ONG' is not translated.
l When the MSTR stock price falls, the Delta value of the convertible bond decreases, because the conversion right of the bond becomes less valuable (closer to "out-of-the-money"). At this time, it is necessary to short more MSTR stocks to match the new Delta value.
l When the MSTR stock price rises, the Delta value of the convertible bond increases, because the conversion right of the bond becomes more valuable (closer to "in-the-money"). At this time, by buying back some of the previously shorted MSTR stocks to match the new Delta value, the hedging of the portfolio is maintained.
Dynamic hedging requires frequent adjustments in the following situations:
l Significant fluctuations in the underlying stock price: such as large changes in the price of leading to violent fluctuations in the MSTR stock price.
l Changes in market conditions: such as volatility, interest rates or other external factors affecting the pricing model of the convertible bond.
l Typically, the hedge fund will trigger operations based on the magnitude of the Delta change (such as every 0.01 change), maintaining the precise hedging of the portfolio.
Let's take a specific scenario to illustrate this. Suppose the initial position of a hedge fund is as follows:
l Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).
l Short $6 million worth of MSTR stocks.
When the stock price rises from $100 to $110, the Delta value of the convertible bond changes to 0.65, and the stock position needs to be adjusted at this time.
The calculation shows that 500,000 shares need to be bought back. The specific operation is to buy back $5 million worth of stocks.
When the stock price falls back 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 500,000 shares need to be shorted. The specific operation is to short $5 million worth of stocks.
This means that when the MSTR price falls, the hedge fund behind its convertible bonds, in order to dynamically hedge the Delta, will short more MSTR stocks, which will further weaken the MSTR stock price, and this will have a negative impact on the positive premium, thereby affecting the entire business model, so the risk on the bond side will be fed back in advance through the stock price. Of course, in the upward trend of MSTR, the hedge fund will buy more MSTR, so it is also a double-edged sword.
