In-depth Analysis of MicroStrategy's Opportunities and Risks - Davis Double-Click and Double Kill

Author | @Web3_Mario

Summary: There is an interesting theme this week, which is the popularity of MicroStrategy. Many predecessors have commented on the company’s operation mode. After digesting and studying it, I have some of my own opinions and would like to share them with you. I think the reason for the rise in MicroStrategy’s stock price is the ‘Davis Double Click’, which combines the appreciation of BTC with the company’s profitability through the innovative design of financing and purchasing BTC, and leverages the funding leverage obtained through the combination of TradFi market financing channels. It enables the company to have the ability to profit from the rise in BTC beyond the appreciation of BTC it holds, and further strengthens this profit rise expectation as the Holdings volume expands. However, the risk lies in this. When the BTC market fluctuates or reverses, the profit rise of BTC will stagnate, and at the same time, affected by the company’s operating expenses and debt pressures, MicroStrategy’s financing capacity will be greatly discounted, thereby affecting the profit rise expectation. At that time, unless there is new assistance to further boost the BTC price, otherwise the relative premium of MSTR’s stock price to BTC Holdings will quickly converge, and this process is called ‘Davis Double Kill’.

What are the Davis double-click and double kill

As my familiar fren should know, I am committed to helping more non-financial professionals understand these dynamics, so I will replay my own thinking logic. So first of all, let’s supplement some basic knowledge, what are ‘Davis Double Click’ and ‘Double Kill’.

The so-called ‘Davis Double Play’ is proposed by investment master Clifford Davis, which is commonly used to describe the phenomenon of significant stock price pump in a favorable economic environment due to two factors. These two factors are:

· Company profit rise: The company has achieved strong profit rise, or its business model, management, etc. have been optimized, leading to an increase in profits.

· Valuation expansion: As the market becomes 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 valuation multiples such as the price-earnings ratio (P/E Ratio) of the stock expand.

The specific logic driving the ‘Davis Double Click’ is as follows. First, the company’s performance exceeds expectations, with both revenue and profits rising. For example, good product sales, expanding market share, or successful cost control will directly lead to a rise in the company’s profits. This kind of rise 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 valuation to expand. This combination of linear and exponential positive feedback effects typically leads to an accelerating pump in stock prices, known as the ‘Davis Double Click’.

To illustrate this process, let’s assume that a company currently has a price-earnings ratio of 15 times and is expected to see a 30% rise in its future earnings. If due to a rise in earnings and changes in market sentiment, investors are willing to pay a price-earnings ratio of 18 times, then even if the earnings growth rate remains unchanged, the increase in valuation will drive the stock price to rise significantly, for example:

Current stock price: $100

Profit rise by 30%, meaning that earnings per share (EPS) increased from $5 to $6.5.

The P/E ratio rose from 15 to 18

New stock price: $6.5×18 = $117

The stock price rose from $100 to $117, reflecting the dual effect of profit rise and valuation increase.

And the ‘Davis Double Kill’ is the opposite, usually used to describe the rapid decline in stock prices due to the combined effect of two negative factors. These two negative factors are:

· Company’s profits decline: The company’s profitability has declined, possibly due to factors such as reduced income, rising costs, management errors, etc., resulting in profits lower than market expectations.

· Valuation contraction: Due to declining profits or deteriorating market prospects, investors’ confidence in the company’s future declines, leading to a contraction in its valuation multiples (such as the P/E ratio) and a decline in stock price.

The whole logic is as follows: first, the company fails to achieve the expected profit target or faces operational difficulties, resulting in poor performance and declining profits. This further worsens market expectations for its future, leading to investor confidence being weak and unwilling to accept the currently overvalued P/E ratio, only willing to pay a lower price for the stock, resulting in a decrease in valuation multiple and further decline in stock price.

To illustrate the process, let’s take an example. Suppose a company currently has a P/E ratio of 15 and is expected to see a 20% drop in future earnings. Due to the decrease in earnings, the market begins to have doubts about the company’s prospects, and investors start to drop its P/E ratio. For example, the P/E ratio may drop from 15 to 12. As a result, the stock price may experience a significant decrease, for instance:

Current stock price: $100

Profit dropped by 20%, meaning earnings per share (EPS) dropped from $5 to $4

PE ratio dropped from 15 to 12

New stock price: $4×12 = $48

The stock price has dropped from $100 to $48, reflecting the dual effects of declining profits and valuation contraction.

This kind of resonance effect usually occurs in high-growth stocks, especially in many technology stocks, which is very evident, because investors are usually willing to give higher expectations for the future rise of these companies’ businesses, but these expectations usually have a relatively large subjective factor support, so the corresponding volatility is also very high.

How did MSTR’s high premium come about, and why has it become the core of its business model

After supplementing this background knowledge, I think everyone should have a general understanding of how MSTR generates a high premium relative to its BTC Holdings. First, MicroStrategy has shifted its business from traditional software to financing the purchase of BTC, and it is not ruled out that there will be corresponding asset management revenue in the future. This means that the company’s profits come from the capital gains of BTC purchased with funds obtained through diluting equity and issuing debt. With the appreciation of BTC, the equity of all investors will correspondingly increase, and investors will benefit from it. In this regard, MSTR is no different from other BTC ETFs.

The difference lies in its financing ability to bring leverage effect, as the rise in MSTR investors’ expectations of future profit comes from the leverage income derived from its financing ability, considering that MSTR’s total Market Cap is relatively at a premium to its total BTC value, meaning that MSTR’s total Market Cap is higher than its total BTC value. As long as it is in this premium state, regardless of equity financing and convertible bond financing, accompanying the funds obtained to buy BTC will further increase equity per share. This gives MSTR the ability to rise profits differently from BTC ETF.

For example, assuming that the current BTC holdings of MSTR are $40 billion and the total circulating shares are X, the total market capitalization is Y. Then the equity per share is $40 billion / X. If financing is done with the most unfavorable dilution of equity, assuming the proportion of new share issuance is a, this means that the total circulating shares become X*(a+1), and financing is completed at the current valuation, raising aY billion dollars. If all of these funds are converted into BTC, then the BTC holdings will change from $40 billion to $40 billion + aY billion, which means that the equity per share will be:

We subtract it from the original earnings per share to calculate the dilutive effect of each share of stock on the earnings per share, as follows:

This means that when Y is greater than 40 billion, that is, the value of BTC held, it means that there is a positive premium, and the completion of financing to purchase BTC brings about a rise in equity per share that is always greater than 0, and the larger the positive premium, the higher the rise in equity per share, the two have a linear relationship, and as for the impact of the dilution ratio a, it exhibits an inverse proportion feature in the first quadrant, which means that the fewer shares issued, the higher the rise in equity.

So, for Michael Saylor, the positive premium of MSTR Market Cap over the value of BTC he holds is the core factor for the success of his business model. Therefore, his optimal choice is how to maintain this premium while continuously financing, increasing his market share, and obtaining more pricing power over BTC. The continuous strengthening of pricing power will enhance investors’ confidence in future growth even in high P/E ratio situations, enabling him to complete fundraising.

In summary, the secret of MicroStrategy’s business model lies in the rise of BTC driving company profits, and a positive trend in BTC rise means a positive trend in corporate profit rise. With the support of this ‘Davis double-click’, MSTR’s premium is starting to expand, so the market is speculating on how high the premium MicroStrategy can value its 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 of this business model lies in significantly increasing the Fluctuation of BTC prices, acting as an amplifier for the Fluctuation. The reason for this is the ‘Davis double kill’, and when BTC enters a high-level oscillation period, it marks the beginning of the entire domino effect.

Let’s imagine a scenario where the BTC’s growth rate slows down and enters a period of oscillation. It is inevitable that MicroStrategy’s profit will start to decline. Here, I want to discuss the importance of its Holdings cost and floating profit scale, which is meaningless. The reason is that in MicroStrategy’s business model, profit is transparent and equivalent to real-time settlement. In the traditional stock market, we know that the factors that cause stock price fluctuations are financial reports. Only when quarterly financial reports are released will the true profit level be confirmed by the market. During this period, investors only estimate changes in financial situation based on external information. In other words, most of the time, the reaction of stock prices lags behind the real revenue changes of the company, and this lagging relationship will be corrected when quarterly financial reports are released. However, in MicroStrategy’s business model, because the holdings scale and the price of BTC are public information, investors can understand the real profit level in real time, and there is no lagging effect because earnings per share change dynamically, equivalent to real-time settlement of profits. In this case, the stock price already reflects all its profits in real time, and there is no lagging effect, so following its holdings cost is meaningless.

To bring the topic back, let’s take a look at how the ‘Davis Double Kill’ unfolded. When the rise of BTC slows down and enters the oscillation phase, MicroStrategy’s profits will continue to drop, even dropping to zero. At this time, the fixed operating costs and financing costs will further reduce the company’s profits, even leading to a loss. This oscillation will continuously erode market confidence in the future price development of BTC. This will translate into doubts about MicroStrategy’s financing capabilities, further undermining expectations of its profit rise. Under the resonance of these two factors, MSTR’s premium will quickly converge. In order to maintain the establishment of its business model, Michael Saylor must maintain the state of the premium. Therefore, it is necessary for MicroStrategy to sell BTC to repurchase stocks, and this is the moment when MicroStrategy begins to sell its first BTC.

Some friends want to ask, why not just hold BTC and let the stock price naturally fall? My answer is no, more precisely, it is not allowed when BTC price reverses. However, it can be tolerated appropriately during oscillations. The reason lies in MicroStrategy’s current equity structure and what is the optimal solution for Michael Saylor.

According to the current MicroStrategy’s shareholding ratio, there are many top financial institutions, such as Jane Street and BlackRock, and the founder Michael Saylor owns less than 10%. Of course, through the design of dual-class shares, Michael Saylor’s voting rights have an absolute advantage, because the shares he holds are mostly Class B common shares, and the voting rights of Class B common shares are in a 10:1 ratio to 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 much higher than the value of the BTC it holds, because assuming the company faces bankruptcy liquidation, it will not obtain much BTC.

So what are the benefits of selling BTC during the oscillation phase and repurchasing stocks to maintain the premium? The answer is also obvious. When the premium converges, assuming that Michael Saylor judges that the P/E ratio of MSTR is undervalued due to panic, it is a cost-effective operation to sell BTC to raise funds and repurchase MSTR from the market. Therefore, at this time, the effect of repurchasing on the Circulating Supply to reduce and enlarge the equity per share will be higher than the effect of reducing the BTC reserve and shrinking the equity per share. When the panic ends and the stock price rebounds, the equity per share will become higher, which is conducive to subsequent development. This effect is easier to understand when MSTR appears at a negative premium in the extreme case of BTC trend reversal.

Considering Michael Saylor’s current position, and when there is volatility or a downward cycle, liquidity is usually tight, so when it starts dumping, the price of BTC will decline faster. The accelerated decline will further worsen investors’ expectations of MicroStrategy’s profitability rise, causing the premium rate to decrease further, which will force them to sell BTC and buy back MSTR, and this is when the ‘Davis Double Kill’ begins.

Of course, there is another reason that forces it to sell BTC to support the stock price, because its investors behind are a group of all-seeing Deep State, impossible to watch the stock price drop to zero and remain indifferent, will definitely put pressure on Michael Saylor, forcing him to take responsibility for its Market Cap management. Moreover, the latest information shows that with continuous dilution of equity, Michael Saylor’s voting rights have fallen below 50%, of course, the specific source of the news has not been found. But this trend seems 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 like to discuss another topic here: whether MicroStrategy has no debt risk in the short term. There have been predecessors who have introduced the nature of MicroStrategy’s convertible bonds, which I will not discuss here. Indeed, its debt duration is quite long. There is indeed no default risk before the maturity date. But my point 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 free call options. At maturity, bondholders can request MicroStrategy to redeem them with stocks of equivalent value at a pre-agreed conversion rate. However, MicroStrategy also has the option to choose the redemption method, either in cash, stocks, or a combination of both, which provides more flexibility. If funds are abundant, more cash can be used for redemption to avoid dilution of equity. If funds are tight, more stocks can be used. Moreover, these convertible bonds are unsecured, so the risk of repayment is relatively small. Additionally, there is a protection for MicroStrategy, which is that if the premium rate exceeds 130%, MicroStrategy can choose to redeem them directly at the original cash value, which creates conditions for loan renewal negotiations.

So the creditors of this bond can only have capital gains if the stock price is higher than the conversion price and lower than 130% of the conversion price, otherwise they will only receive the principal plus low interest. Of course, after being reminded by Teacher Mindao, it is mainly hedge funds that invest in this bond for Delta hedging and to earn Volatility returns. Therefore, I have carefully considered the underlying logic.

The specific operation of Delta hedging through convertible bonds is mainly to buy MSTR convertible bonds and short an equal amount of MSTR stocks to hedge the risk of stock price fluctuation. And with the subsequent price development, the hedging fund needs to continuously adjust the dynamic hedging position. And dynamic hedging usually has the following two scenarios:

· When the MSTR stock price drops, the Delta value of the convertible bonds drops, because the conversion right of the bonds becomes less valuable (closer to ‘out of the money’). At this point, it is necessary to short more MSTR stocks to match the new Delta value.

· When the MSTR stock price pumps, the Delta value of the convertible bonds increases, as the conversion right of the bonds becomes more valuable (closer to the “in-the-money”). At this time, the hedging of the portfolio can be maintained by buying back some of the previously shorted MSTR stocks to match the new Delta value.

Dynamic Hedging requires frequent adjustments under the following circumstances:

· Significant Fluctuation in the underlying stock price: such as significant changes in BTC price leading to MSTR’s stock price experiencing dramatic Fluctuation.

· Market conditions changes: such as Volatility, Interest Rate or other external factors affecting convertible bond pricing models.

· Typically, Hedging funds will trigger operations based on the magnitude of Delta changes (such as every 0.01 change), to maintain accurate Hedging of the portfolio.

Let’s take a specific scenario to illustrate. Suppose the initial Holdings of a Hedging fund are as follows

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

· Sell short $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. At this time, the stock position needs to be adjusted. The calculation requires repurchasing 500,000 stocks, which is (0.65-0.6)×10 million = 500,000. The specific operation is to buy back $500,000 worth of stocks.

And 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. Calculating the need to increase short positions in stocks by (0.6-0.55)×10 million = 50,000. The specific operation is to short sell $500,000 worth of stocks.

This means that when the MSTR price falls, the hedging fund behind its convertible bonds will sell more MSTR stocks to dynamically hedge Delta, which will further hit the MSTR stock price and have a negative impact on the positive premium, thereby affecting the entire business model. Therefore, the risk on the bond side will be reflected in the stock price in advance. Of course, in the upward trend of MSTR, the hedging fund will buy more MSTR, so it is also a double-edged sword.