Last week we discussed Lidos potential to benefit from changes in the regulatory environment , hoping to help everyone seize this wave of Buy the rumor trading opportunities. This week there is an interesting topic, which is the popularity of MicroStrategy. Many predecessors have commented on the operating model of this company. After digesting and studying it in depth, I have some of my own opinions and hope to share them with you. I think the reason for MicroStrategys stock price rise is the Davis Double Click. Through the business design of financing the purchase of BTC, the appreciation of BTC is tied to the companys profits, and the capital leverage obtained by combining the innovative design of traditional financial market financing channels has enabled the company to have the ability to exceed the profit growth brought by the appreciation of BTC it holds. At the same time, as the holdings expand, the company has a certain BTC pricing power, further strengthening this profit growth expectation. And this is also the risk. When the BTC market is volatile or faces the risk of reversal, BTCs profit growth will stagnate. At the same time, affected by the companys operating expenses and debt pressure, MicroStrategys financing ability will be greatly reduced, which will in turn affect profit growth expectations. At that time, unless there is new support to further push up the BTC price, the positive premium of MSTRs stock price relative to BTC holdings will converge rapidly. This process is the so-called Davis double kill.
What is Davis double-click and double-kill?
Friends who are familiar with me should know that I am committed to helping more non-financial professionals understand these dynamics, so I will replay my own thinking logic. Therefore, I will first add some basic knowledge, what is Davis Double Click and Double Kill.
The so-called Davis Double Play was proposed by investment guru Clifford Davis. It is usually used to describe the phenomenon that in a good economic environment, a companys stock price rises sharply due to two factors. These two factors are:
Company profit growth: The company has achieved strong profit growth, or the optimization of its business model, management, etc. has led to profit improvement.
Valuation expansion: As the market becomes more optimistic about the companys prospects, investors are willing to pay a higher price for it, which drives up stock valuations. In other words, valuation multiples such as the stocks price-to-earnings ratio (P/E Ratio) expand.
The specific logic driving the Davis Double Click is as follows: first, the companys performance exceeded expectations, and both revenue and profits were growing. For example, good product sales, expanded market share, or successful cost control will directly lead to the companys profit growth. This growth will also increase the markets confidence in the companys future prospects, leading investors to be willing to accept a higher price-to-earnings ratio (P/E), pay a higher price for the stock, and the valuation begins to expand. This positive feedback effect of combining linear and exponential factors usually leads to an accelerated rise in stock prices, which is the so-called Davis Double Click.
To illustrate this process, suppose a companys current P/E ratio is 15 times, and its future earnings are expected to grow by 30%. If investors are willing to pay 18 times the P/E ratio for the company due to the growth of its earnings and changes in market sentiment, then even if the earnings growth rate remains unchanged, the increase in valuation will drive the stock price up significantly, for example:
Current share price: $100
A 30% increase in earnings means that earnings per share (EPS) increased from $5 to $6.5.
The price-to-earnings ratio increased from 15 to 18.
New stock price: $6.5 × 18 = $117
The share price rose from $100 to $117, reflecting the dual effects of earnings growth and valuation improvement.
The Davis Double Kill is the opposite, usually used to describe the rapid decline in stock prices caused by the combined effect of two negative factors. The two negative factors are:
Decline in company profitability: Decline in company profitability may be due to factors such as reduced revenue, rising costs, and management errors, which result in lower earnings than market expectations.
Valuation contraction: Due to declining earnings or worsening market prospects, investors confidence in a companys future declines, causing its valuation multiples (such as the price-to-earnings ratio) to decline and its stock price to fall.
The whole logic is as follows: first, the company fails to achieve the expected profit target or faces operating difficulties, resulting in poor performance and declining profits. This will further worsen the markets expectations for its future, investors lack confidence, are unwilling to accept the current overestimated price-to-earnings ratio, and are only willing to pay a lower price for the stock, resulting in a decline in valuation multiples and a further decline in stock prices.
Lets take an example to illustrate this process. Suppose a companys current P/E ratio is 15 times, and its future earnings are expected to fall by 20%. As earnings fall, the market begins to have doubts about the companys prospects, and investors begin to lower its P/E ratio. For example, lowering the P/E ratio from 15 to 12. The stock price may fall sharply as a result, for example:
Current share price: $100
A 20% drop in earnings means earnings per share (EPS) falls from $5 to $4.
The price-to-earnings ratio dropped from 15 to 12.
New stock price: $4 × 12 = $48
The share price fell from $100 to $48, reflecting the combined effects of declining earnings and shrinking valuations.
This resonance effect usually occurs in high-growth stocks, especially in many technology stocks, because investors are usually willing to have higher expectations for the future growth of these companies businesses. However, such expectations are usually supported by relatively large subjective factors, so the corresponding volatility is also large.
How did MSTR’s high premium come about and why did it become the core of its business model?
After adding this background knowledge, I think everyone should be able to roughly understand how MSTRs high premium relative to its BTC holdings came about. First of all, MicroStrategy switched its business from traditional software business to financing the purchase of BTC, and of course it does not rule out corresponding asset management revenue in the future. This means that the companys profits come from the capital gains from the appreciation of BTC purchased with funds obtained through equity dilution and bond issuance. With the appreciation of BTC, the shareholders equity of all investors will increase accordingly, and investors will benefit from it. In this respect, MSTR is no different from other BTC ETFs.
The difference lies in the leverage effect brought by its financing ability, because MSTR investors expectations of the companys future profit growth come from the leveraged benefits obtained from the growth of its financing ability. Considering that the total market value of MSTRs stocks is in a positive premium state relative to the total value of BTC it holds, that is, the total market value of MSTR is higher than the total value of BTC it holds. As long as it is in this positive premium state, whether it is equity financing or its convertible bond financing, as the funds obtained are used to purchase BTC, the equity per share will be further increased. This gives MSTR the ability to grow profits that is different from BTC ETF.
For example, suppose that MSTR currently holds 40 billion USD in BTC, with a total of X shares outstanding and a total market value of Y. Then the equity per share is 40 billion / X. If the most unfavorable equity dilution is used for financing, assuming that the proportion of new shares issued is a, this means that the total outstanding shares become X * (a + 1), and the financing is completed at the current valuation, raising a * Y billion USD in total. If all these funds are converted into BTC, the BTC holdings will become 40 billion + a * Y billion, which means that the equity per share becomes:
We subtract it from the original earnings per share to calculate the increase in diluted equity per share, as follows:
This means that when Y is greater than 40 billion, which is the value of the BTC it holds, that is, when there is a positive premium, the equity growth per share brought about by completing the financing to purchase BTC is always greater than 0, and the greater the positive premium, the higher the equity growth per share. The two are called a linear relationship. As for the impact of the dilution ratio a, it presents an inverse proportional characteristic in the first quadrant, which means that the fewer additional shares issued, the higher the equity growth.
Therefore, for Michael Saylor, the positive premium between the market value of MSTR and the value of the BTC it holds is the core factor in the establishment of its business model. Therefore, his best choice is to maintain this premium while continuously raising funds, increasing his market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will increase investors confidence in future growth even at a high price-to-earnings ratio, enabling them to complete fundraising.
To sum up, the secret of MicroStrategys business model lies in the fact that the appreciation of BTC drives up the companys profits, and the positive growth trend of BTC means a positive growth trend of corporate profits. With the support of this Davis Double Click, the positive premium of MSTR begins to expand, so the market is betting on how high a positive premium valuation MicroStrategy can use to complete subsequent financing.
What risks does MicroStrategy pose to the industry?
Next, lets talk about the risks that MicroStrategy brings to the industry. I think the core is that this business model will significantly increase the volatility of BTC prices and act as an amplifier of volatility. The reason is the Davis double kill, and BTC entering a high-level oscillation period is the beginning of the entire domino effect.
Lets imagine that when the growth of BTC slows down and enters a period of volatility, MicroStrategys profits will inevitably begin to decline. I want to expand on this here. I see that some friends attach great importance to their holding costs and the scale of floating profits. This is meaningless because in MicroStrategys business model, profits are transparent and equivalent to real-time settlement. In the traditional stock market, we know that the real factor causing stock price fluctuations is financial reports. Only when quarterly financial reports are released 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, most of the time, the reaction of stock prices lags behind the actual changes in the companys earnings, and this lagging relationship will be corrected when the quarterly financial reports are released. However, in MicroStrategys business model, since its holding size and BTC prices are public information, investors can understand its real profit level in real time, and there is no lag effect, because the equity per share changes dynamically with it, which is equivalent to real-time settlement of profits. In this 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.
Lets go back to the topic and see how the Davis Double Kill unfolds. When BTCs growth slows down and enters the oscillation stage, MicroStrategys profits will continue to decline, or even return to zero. At this time, fixed operating costs and financing costs will further reduce corporate profits, or even be in a state of loss. At this time, this shock will continue to erode the markets confidence in the subsequent development of BTC prices. This will translate into doubts about MicroStrategys financing capabilities, which will further undermine expectations for its profit growth. Under the resonance of these two, MSTRs positive premium will converge quickly. In order to maintain the establishment of its business model, Michael Saylor must maintain the state of positive premium. Therefore, it is necessary to sell BTC in exchange for funds to repurchase stocks, and this is when MicroStrategy began to sell its first BTC.
Some friends may ask, can’t we just hold BTC and let the stock price fall naturally? My answer is no, to be more precise, it is not allowed when the BTC price reverses, but it can be tolerated appropriately when it fluctuates. The reason lies in MicroStrategy’s current equity structure and what is the best solution for Michael Saylor.
According to the current shareholding ratio of MicroStrategy, there are many top 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 has an absolute advantage in voting rights, because the shares he holds are more Class B common shares, and the voting rights of Class B common shares are 10:1 with Class A. Therefore, the 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 if the company faces bankruptcy and liquidation, he will not be able to obtain much BTC.
So what are the benefits of selling BTC during the shock phase and buying back stocks to maintain the premium? The answer is also obvious. When the premium converges, assuming that Michael Saylor judges that MSTRs P/E ratio is undervalued due to panic, it is a good deal to sell BTC in exchange for funds and buy back MSTR from the market. Therefore, the effect of repurchase on the reduction of circulation and amplifying the equity per share will be higher than the effect of reducing the equity per share due to the reduction of BTC reserves. When the panic ends, the stock price will pull back, and the equity per share will become higher, which is conducive to subsequent development. This effect is easier to understand when MSTR has a negative premium in the extreme case of BTC trend reversal.
Considering Michael Saylors current holdings, and the fact that liquidity is usually tightened when there is a shock or downward cycle, when he starts to sell, the price of BTC will fall faster. The accelerated decline will further worsen investors expectations for MicroStrategys profit growth, and the premium rate will further decline, which will force him to sell BTC to repurchase MSTR, and the Davis double kill will begin.
Of course, another reason that forced him to sell BTC to maintain the stock price is that the investors behind it are a group of all-powerful Deep State, and it is impossible for them to watch the stock price drop to zero and remain indifferent, which will inevitably put pressure on Michael Saylor and force him to take responsibility for market value management. In addition, recent information shows that with the continuous dilution of equity, Michael Saylors voting rights have fallen below 50%. Of course, the specific source of the news has not been found. But this trend seems inevitable.
Are MicroStrategys convertible bonds really risk-free before maturity?
After the above discussion, I think I have fully explained my logic. I would like to discuss another topic, whether MicroStrategy has no debt risk in the short term. Some predecessors have already introduced the nature of MicroStrategys convertible bonds, so I will not discuss it here. Indeed, its debt duration is quite long. There is indeed no repayment risk before the maturity date. But my point of view is that its debt risk may still be reflected in advance through the stock price.
The convertible bonds issued by MicroStrategy are essentially bonds with free call options superimposed on them. When they expire, creditors can ask MicroStrategy to redeem them at the previously agreed conversion rate and stock equivalent. However, there is also protection for MicroStrategy here, that is, MicroStrategy can actively choose the redemption method, using cash, stock, or a combination of the two. This is relatively flexible. If there is sufficient funds, more cash can be repaid to avoid equity dilution. If there is not sufficient funds, more stocks can be used. Moreover, this convertible bond is unsecured, so the risk of debt repayment is indeed not great. And there is another protection for MicroStrategy here, that is, if the premium rate exceeds 130%, MicroStrategy can also choose to redeem directly in cash at the original value, which creates conditions for renewal loan negotiations.
Therefore, the creditors of this bond will only have capital gains when the stock price is higher than the conversion price and lower than 130% of the conversion price. Otherwise, they will only have the principal plus low interest. Of course, as Mr. Mindao reminded me, the investors of this bond are mainly hedge funds that use it for Delta hedging to earn volatility returns. Therefore, I thought about the logic behind it in detail.
Delta hedging through convertible bonds The specific operation is mainly to purchase MSTR convertible bonds and short sell an equal amount of MSTR stocks at the same time to hedge the risks brought by stock price fluctuations. In addition, with the subsequent price development, hedge funds need to constantly adjust their positions for dynamic hedging. Dynamic hedging usually has the following two scenarios:
When MSTR stock price drops, the convertible bonds Delta value decreases because the bonds conversion right becomes less valuable (closer to out of the money). More MSTR stock needs to be sold short to match the new Delta value.
When 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, the portfolio is hedged by buying back some of the previously shorted MSTR shares to match the new Delta value.
Dynamic hedging requires frequent adjustments in the following situations:
Significant fluctuations in the underlying stock price: For example, large changes in the price of Bitcoin may cause MSTRs stock price to fluctuate dramatically.
Changes in market conditions: such as volatility, interest rates or other external factors that affect the convertible bond pricing model.
Typically, hedge funds trigger operations based on the magnitude of the change in Delta (such as every change of 0.01) to maintain precise hedging of the portfolio.
Lets take a specific scenario to illustrate. Suppose a hedge funds initial holdings are as follows
Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).
Shorted $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, and the stock position needs to be adjusted. The number of shares to be covered is (0.65 − 0.6) × 10 million = 500,000. The specific operation is to buy back $500,000 worth of stocks.
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 requires adding short stocks to (0.6 − 0.55) × 10 million = 500,000. The specific operation is to short sell $500,000 worth of stocks.
This means that when the price of MSTR falls, the hedge funds behind its convertible bonds will short sell more MSTR shares in order to dynamically hedge Delta, which will further hit the MSTR stock price, which will have a negative impact on the positive premium and thus affect the entire business model. Therefore, the risk on the bond side will be fed back in advance through the stock price. Of course, in the upward trend of MSTR, hedge funds will buy more MSTR, so it is also a double-edged sword.
