The Opportunities and Risks of MicroStrategy: The Davis Effect of Profit and Loss Originating from the Same Source

Last week we discussed Lido's potential benefits in the changing regulatory environment, hoping to help everyone seize this "Buy the rumor" trading opportunity. This week, we will explore an interesting topic - the popularity of MicroStrategy. After digesting and researching in-depth, I would like to share some personal insights.

I believe the reason for the increase in MicroStrategy's stock price is the "Davis Double-Whammy" effect. By designing a business model that finances the purchase of BTC, the appreciation of BTC is linked to the company's profitability, and through innovative designs in financing channels in traditional financial markets, it gains financial leverage, enabling the company to achieve profit growth that surpasses the appreciation of its BTC holdings. At the same time, as the holding volume expands, the company gains a certain pricing power over BTC, further strengthening this profit growth expectation.

However, its risks also stem from this. When the BTC market experiences fluctuations or reversal risks, the profit growth of BTC will come to a standstill. At the same time, affected by the company's operating expenses and debt pressure, MicroStrategy's financing ability will be greatly discounted, which will further impact profit growth expectations. Unless there is new support to further boost BTC prices, the positive premium of MSTR stock price relative to BTC holdings will quickly converge, a process known as "Davis Double Kill".

What is Davis Double Hit and Double Kill

"Davis Double Click" is usually used to describe the phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment:

1. Company Profit Growth: The company has achieved strong profit growth, or the optimization of business models, management, and other areas has led to an increase in profits.

2. Valuation Expansion: The market is more optimistic about the company's prospects, and investors are willing to pay higher prices, driving up stock valuations.

The specific logic is that the company's performance exceeds expectations, with revenue and profit growth. This directly leads to profit growth, while enhancing the market's confidence in the company's future prospects, causing investors to be willing to accept higher price-to-earnings ratios, paying higher prices for the stock, and valuation begins to expand. This combination of linear and exponential positive feedback effects usually leads to an accelerated rise in stock prices.

The "Davis Double Kill" is the opposite, describing a rapid decline in stock prices caused by the combined effects of two negative factors:

1. Decline in company profits: The decline in profitability may be due to factors such as reduced revenue, increased costs, and management errors, resulting in profits falling below market expectations.

2. Valuation contraction: Due to a decline in earnings or a worsening market outlook, investors' confidence in the company's future decreases, leading to a decline in valuation multiples and a drop in stock prices.

This resonance effect usually occurs in high-growth stocks, especially evident in technology stocks. Investors are often willing to assign higher expectations for the future business growth of these companies; however, such expectations often contain a significant subjective component, leading to greater volatility.

The Formation of MSTR's High Premium and Its Core Business Model

MicroStrategy has shifted its business from traditional software to financing the purchase of BTC, which means that the company's profit sources come from capital gains obtained by diluting equity and raising funds through bond issuance to purchase appreciating BTC. As BTC appreciates, the equity of all investors increases correspondingly, making MSTR no different from other BTC ETFs in this regard.

The difference lies in the leverage effect brought by its financing capability. MSTR investors' expectations for the company's future profit growth come from the leveraged gains obtained through the growth of its financing capability. Considering that MSTR's total stock market value is in a state of positive premium relative to the total value of its held BTC, as long as this positive premium is maintained, whether through equity financing or convertible bond financing, acquiring funds to purchase BTC will further increase the equity per share. This gives MSTR a different profit growth capability compared to BTC ETFs.

For Michael Saylor, the premium of MSTR's market capitalization over the value of its held BTC is a core factor for the validity of the business model. His optimal choice is to maintain this premium while continuously financing, increasing market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will also boost investors' confidence in future growth under high price-to-earnings ratios, enabling him to raise funds.

In summary, the mystery of MicroStrategy's business model lies in the appreciation of BTC driving the company's profit increase. A positive growth trend in BTC implies a positive growth trend in corporate profits. Under this "Davis Double Play" support, MSTR is beginning to amplify its premium, and the market is speculating on how high a premium valuation MicroStrategy can achieve for subsequent financing.

Risks Brought by MicroStrategy to the Industry

MicroStrategy brings risks to the industry as this business model significantly increases the price volatility of BTC, acting as a volatility amplifier. The reason lies in the "Davis double whammy", and the period when BTC enters a high-level oscillation is the stage where the entire domino effect begins.

As BTC growth slows and enters a consolidation phase, MicroStrategy's profits will continuously decline, potentially even reaching zero. At this point, fixed operating costs and financing costs will further shrink corporate profits, possibly leading to losses. This oscillation will gradually erode market confidence in the future price development of BTC, transforming it into doubts about MicroStrategy's financing capabilities, further undermining its profit growth expectations. In resonance between these two factors, MSTR's positive premium will quickly converge. To maintain the business model, Michael Saylor must uphold the positive premium status. Therefore, selling BTC to raise funds to repurchase stock is a necessary operation, marking the moment MicroStrategy began selling its first BTC.

Considering Michael Saylor's current holdings, and that liquidity usually tightens during periods of volatility or downturn, when he starts to sell, the decline in BTC prices will accelerate. This accelerated decline will further worsen investors' expectations for MicroStrategy's profit growth, leading to a further drop in the premium rate, which in turn forces him to sell BTC to buy back MSTR, at which point the "Davis double kill" begins.

Another reason that forces him to sell BTC to maintain the stock price is that the investors behind it are a group of powerful consortiums who cannot passively watch the stock price drop to zero. This will inevitably put pressure on Michael Saylor and force him to take on the responsibility of market value management. Moreover, recent information shows that with the continuous dilution of equity, Michael Saylor's voting power has fallen below 50%. Although specific sources for this news have not been found, this trend seems to be unavoidable.

The Risks of MicroStrategy's Convertible Bonds

Although MicroStrategy's convertible bonds have a long maturity and seem to have no repayment risk before the due date, I believe that its debt risk may still be reflected in the stock price in advance.

The convertible bonds issued by MicroStrategy are essentially bonds that come with a free call option. Upon maturity, creditors can request redemption at an agreed conversion rate for an equivalent amount of stock, but MicroStrategy can also choose to redeem in cash, stock, or a combination of both, providing a level of flexibility. If funds are abundant, they can repay more in cash to avoid dilution of equity; if funds are limited, they can utilize more stock. Moreover, these convertible bonds are unsecured, so the risk of default is indeed low. Additionally, when the premium rate exceeds 130%, MicroStrategy can opt for direct cash redemption at par value, creating conditions for loan renewal negotiations.

Therefore, the creditor of this bond will only have capital gains when the stock price is above the conversion price but below 130% of the conversion price; otherwise, there will only be the principal plus low interest. However, it should be noted that the main investors in this type of bond are hedge funds, used for Delta hedging to earn volatility returns.

The specific operation of Delta hedging through convertible bonds is to purchase MSTR convertible bonds while shorting an equal amount of MSTR stock to hedge against stock price volatility risk. Subsequently, it is necessary to continuously adjust the position for dynamic hedging.

• When the MSTR stock price falls, the Delta value of the convertible bonds decreases, requiring more short selling of MSTR shares to match the new Delta value.
• When the MSTR stock price rises, the Delta value of the convertible bonds increases, requiring the repurchase of some previously shorted MSTR shares to match the new Delta value.

This means that when the MSTR price falls, the hedge funds behind the convertible bonds will dynamically hedge Delta by shorting more MSTR stocks, further driving down the MSTR stock price, negatively affecting the premium and, in turn, impacting the entire business model. Therefore, the risk on the bond side will be reflected in the stock price in advance. Of course, in an upward trend for MSTR, hedge funds will buy more MSTR, so this is a double-edged sword.