In-depth analysis of MicroStrategy's opportunities and risks: Davis double hit and double kill

Author: ++@Web3++ ++_Mario++

Abstract: 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, there is an interesting theme regarding the popularity of MicroStrategy. Many predecessors have commented on the operational model of this company. After digesting and researching, I have some personal 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, it binds the appreciation of BTC to the company's profits. The innovative design that combines traditional financial market financing channels provides a leverage effect, enabling the company to achieve profit growth that exceeds the appreciation of its BTC holdings. As the holding volume expands, the company gains a certain pricing power over BTC, further reinforcing this profit growth expectation. However, the risk lies in this; when the BTC market experiences fluctuations or reversal risks, the profit growth from BTC will stagnate. Meanwhile, affected by the company's operating expenses and debt pressure, MicroStrategy's financing ability will be significantly reduced, which in turn affects profit growth expectations. Unless there is new support to further boost BTC prices, the relative premium of MSTR's stock price over its BTC holdings will quickly converge, a process known as the "Davis Double Kill."

What is the Davis Double Play 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 thinking logic. Therefore, I will first supplement some basic knowledge about what the "Davis Double Play" and "Double Kill" are.

The so-called "Davis Double Play" is proposed by investment master Clifford Davis, usually used to describe the phenomenon where a company's stock price rises sharply 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 profit enhancement.

• 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 the stock's valuation. 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's performance exceeds expectations, with both revenue and profit growing. For example, strong product sales, expanded market share, or successful cost control will directly lead to the company's 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 the valuation to begin to expand. This linear and exponential combined positive feedback effect usually leads to accelerated stock price increases, 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 an 18 times P/E ratio, then even if the profit growth rate remains unchanged, the increase in valuation will significantly push up the stock price. For example:

• Current stock price: $100

• Profit growth of 30%, meaning earnings per share (EPS) increase from $5 to $6.5.

• P/E 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 enhancement.

On the other hand, the "Davis Double Kill" is the opposite, usually used to describe the rapid decline in stock price due to the combined effects 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, etc., leading to profits falling below market expectations.

• Valuation contraction: Due to profit decline or worsening market prospects, investor confidence in the company's future declines, leading to a decrease in its valuation multiples (such as P/E ratio) and a drop in stock price.

The entire logic is as follows: first, the company fails to meet expected profit targets or faces operational difficulties, leading to poor performance and profit decline. This further worsens market expectations for its future, causing investor confidence to wane, and they are unwilling to accept the currently high P/E 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, suppose a company's current P/E ratio is 15 times, and its future profits are expected to decline by 20%. Due to the profit decline, 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:

• Current stock price: $100

• Profit decline of 20%, meaning EPS decreases from $5 to $4.

• P/E ratio decreases from 15 to 12.

• New stock price: $4 × 12 = $48

The stock price drops from $100 to $48, reflecting the dual effects of profit decline and valuation contraction.

This resonance effect usually occurs in high-growth stocks, especially evident in many tech stocks, as investors are often willing to assign high expectations for future growth to these companies. However, such expectations are usually supported by significant subjective factors, leading to considerable volatility.

How MSTR's High Premium is Created and Why It Becomes the Core of Its Business Model

After supplementing this background knowledge, I believe everyone should have a general understanding of how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy has shifted its business from traditional software to financing for BTC purchases, and future asset management revenue cannot be ruled out. This means that the company's profit comes from the capital gains of BTC purchased with funds obtained through equity dilution and bond issuance. As BTC appreciates, all investors' equity will correspondingly increase, benefiting investors, making MSTR similar to other BTC ETFs in this regard.

The distinction lies in the leverage effect brought about by its financing ability. Investors in MSTR expect the company's future profit growth to come from the leverage gains obtained through its financing capabilities. Considering that MSTR's total market value is at a premium relative to the total value of its BTC holdings, this means that MSTR's total market value exceeds the total value of its BTC holdings. As long as it remains in this premium state, whether through equity financing or convertible bond financing, the funds obtained will be used to purchase BTC, further increasing the equity per share. This gives MSTR a profit growth capability that is different from BTC ETFs.

To illustrate, suppose MSTR currently holds $40 billion in BTC, with total outstanding shares X and total market value Y. At this time, the equity per share is $40 billion / X. In the worst-case scenario of equity dilution, suppose the new share issuance ratio is a, meaning the total outstanding shares become X * (a + 1). If financing is completed at the current valuation, a total of a * Y billion dollars will be raised. If all these funds are converted into BTC, the BTC holdings will become $40 billion + a * Y billion, meaning the equity per share becomes:

We will subtract this from the original equity per share to calculate the growth of equity per share due to diluted shares, as follows:

This means that when Y is greater than $40 billion, which is the value of its BTC holdings, it indicates the existence of a premium. Completing financing to purchase BTC will lead to a growth in equity per share that is always greater than 0. The larger the premium, the higher the growth in equity per share, which shows a linear relationship. As for the impact of the dilution ratio a, it presents an inverse relationship in the first quadrant, meaning that the fewer new shares issued, the higher the growth rate of equity.

Therefore, for Michael Saylor, the positive premium of MSTR's market value relative to 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 boost investor confidence in future growth even at high P/E ratios, enabling him 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 indicates a positive trend in corporate profit growth. Under this support of the "Davis Double Play," MSTR's premium begins to amplify, so the market is betting on how high a premium valuation MicroStrategy can achieve for 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 issue is 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-level fluctuation is the beginning of the entire domino effect.

Let us imagine that when BTC's growth slows down and enters a fluctuation period, MicroStrategy's profits will inevitably begin to decline. Here, I want to elaborate on this point. I have seen some friends place great importance on its holding cost 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 released can 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's reaction lags behind the company's real revenue changes, and this lagging relationship will be corrected when each quarterly financial report is released. However, in MicroStrategy's business model, since 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 the equity per share changes dynamically, equivalent to real-time profit settlement. Therefore, the stock price already reflects all profits accurately, and there is no lag effect, making it meaningless to focus on its holding cost.

Returning to the topic, let's see how the "Davis Double Kill" unfolds. When BTC's growth slows down and enters a fluctuation phase, MicroStrategy's profits will continuously decrease, even approaching zero. At this time, fixed operating costs and financing costs will further shrink corporate profits, potentially leading to losses. This fluctuation will continuously erode market confidence in the future development of BTC prices. This will translate into doubts about MicroStrategy's financing ability, further undermining expectations for its profit growth. Under the resonance of these two factors, MSTR's premium will quickly converge. To maintain the validity of its business model, Michael Saylor must maintain the state of premium. Therefore, selling BTC to buy back shares is a necessary operation, and this is the moment MicroStrategy begins to sell its first BTC.

Some friends may ask, why not just hold BTC and let the stock price naturally fall? My answer is no, to be more precise, it is not possible when BTC prices reverse; it can be tolerated during fluctuations. The reason lies in MicroStrategy's current equity structure and what constitutes the optimal solution for Michael Saylor.

According to the current shareholding ratio of MicroStrategy, there are several top-tier consortiums, such as Jane Street and BlackRock, while the founder Michael Saylor holds less than 10%. Of course, through a dual-class share structure, Michael Saylor has absolute voting power, as he holds more Class B common shares, and the voting power of Class B shares is 10:1 compared to Class A shares. 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 long-term value of the company is far greater than the value of the BTC he holds because, in the event of bankruptcy liquidation, he would not receive much BTC.

So what are the benefits of selling BTC during the fluctuation phase to buy back shares to maintain the premium? The answer is 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 buying back MSTR from the market is a profitable operation. Therefore, at this time, the effect of reducing the circulating volume through buybacks will amplify the equity per share effect more than the effect of reducing equity per share due to the decrease in BTC reserves. When the panic ends and the stock price rebounds, the equity per share will thus become higher, benefiting future development. This effect is easier to understand in extreme cases when BTC's trend reverses and MSTR appears at a negative premium.

Considering Michael Saylor's current holding volume, when fluctuations or downward cycles occur, liquidity is usually tight. Therefore, when he starts to sell, the price of BTC will accelerate its decline. The acceleration of the decline 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 buy back MSTR, marking the beginning of the "Davis Double Kill."

Of course, another reason that forces him to sell BTC to maintain the stock price is that the investors behind him are a group of influential Deep State players who cannot passively watch the stock price approach zero without taking action, which will inevitably put pressure on Michael Saylor, forcing him to take responsibility for managing the company's market value. Moreover, recent information indicates that with continuous equity dilution, Michael Saylor's voting power has fallen below 50%. However, I have not found specific sources for this information. But this trend seems inevitable.

Is MicroStrategy's Convertible Bond Really Risk-Free Before Maturity?

After the above discussion, I believe 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 elaborate on that here. Indeed, its debt duration is quite long. There is no repayment risk before the maturity date. 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 with a free call option. Upon maturity, creditors can require MicroStrategy to redeem them with shares equivalent to the previously agreed conversion rate. However, there is also protection for MicroStrategy; it can actively choose the redemption method, using cash, shares, or a combination of both. This provides some flexibility; if funds are sufficient, it can repay more in cash to avoid equity dilution. If funds are insufficient, it can issue more shares. Moreover, this convertible bond is unsecured, so the risk from debt repayment is indeed low. Additionally, there is another protection for MicroStrategy: if the premium exceeds 130%, MicroStrategy can also choose to redeem it directly in cash at par value, creating conditions for refinancing negotiations.

Therefore, the creditors of this bond will only have capital gains if the stock price is above the conversion price and below 130% of the conversion price. Otherwise, they will only receive the principal plus low interest. Of course, as pointed out by Mr. Mindao, the main investors in this bond are hedge funds using it for Delta hedging to earn volatility returns. Therefore, I have thought through the underlying logic.

Delta hedging through convertible bonds mainly involves purchasing MSTR convertible bonds while shorting an equivalent amount of MSTR stock to hedge against the risks brought by stock price fluctuations. As the price develops, hedge funds need to continuously adjust their positions for dynamic hedging. Dynamic hedging usually involves the following two scenarios:

• When MSTR's 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 point, more MSTR stock needs to be shorted to match the new Delta value.

• When MSTR's 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 point, some 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 frequently adjusted under the following circumstances:

• Significant fluctuations in the underlying stock price: For example, drastic changes in Bitcoin prices lead to sharp fluctuations in MSTR's stock price.

• 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 (e.g., every change of 0.01) to maintain precise hedging of the portfolio.

Let us illustrate this with a specific scenario. Suppose a hedge fund's initial position is as follows:

• Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).

• 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, requiring an adjustment of the stock position.

The calculation for the number of shares to cover 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 falls from $100 to $95, the new Delta value of the convertible bond changes to 0.55, requiring an adjustment of the stock position.

The calculation for the additional short stock is (0.6−0.55)×$10 million = $500,000. The specific operation is to short an additional $500,000 worth of stock.

This means that when MSTR's price falls, the hedge fund behind the convertible bond will sell more MSTR stock to dynamically hedge Delta, further driving down MSTR's stock price, which will negatively impact the premium and, in turn, affect 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.