Management doesn’t always know best. Here’s why…

From the desk of Miles Everson:

Investing has enabled many folks to attain financial security and independence for decades.

That’s why every Wednesday, I share investing insights to help others build their wealth through this activity.

In today’s  “The Independent Investor,”  I’ll talk about compensation plans, and how they can affect a company’s direction.

Curious?

Keep reading below to know why!

Management doesn’t always know best. Here’s why…

Geothermal energy is in the spotlight yet again because of artificial intelligence (AI).

This is because aside from semiconductor chips, the single greatest bottleneck in the AI revolution is  power.

As a consequence, firms and even countries are turning to all forms of energy, including geothermal, positioning  Ormat Technologies  favorably.

Ormat Technologies is one of the biggest pure-play geothermal firms in the world, operating roughly 200 power plants spanning geothermal, recovered energy generation, and other related infrastructure.

Investor expectations on Ormat Technologies have likewise risen as it’s seen as a crucial player in the energy and AI industries.

According to  Professor Joel Litman, Chairman and CEO of  Valens Research  and Chief Investment Officer of  Altimetry Financial Research, investors are expecting Ormat Technologies to deliver a Uniform return on assets (ROA) of 8% by 2029, more than double the returns it delivered in 2024.

These are lofty expectations for the company, so can it meet them?

Well, the answer isn’t as straightforward as we’d like it to be… and it’s not because Ormat Technologies’ business is flawed.

The problem lies in its compensation structure for its management team.

Before we go any deeper, allow us to talk about the concept of  “incentives dictate behavior”  first.

The concept is simple: Management does what it’s paid to do. Hence, whatever step a leadership team takes is directly tied to the incentives they have to work with.

You see, unlike most salaried employees, executives of public companies have multiple sources of compensation (The Definitive Proxy Statement, or DEF 14A, breaks all of this down).

These executives have an annual salary, but they also get performance-based pay. Some of these cash awards are based on annual performance targets. The largest payouts usually come from long-term stock compensation.

According to Professor Litman, for Ormat's executive team, stock awards formed at least half of each director's compensation in 2024.

The company's board of directors—specifically the compensation committee—decides what management must do to receive extra compensation.

Short-term awards are based on revenue and adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). Both metrics encourage management to grow the business.

That’s not a bad strategy when energy demand is sky-high.

However, it should be noted that in the longer term, Ormat’s management is paid for two things: Stock performance and new megawatts (MW) of power generated.

Managers want their company's stock to perform well, and it would seem like adding more MW is a good thing… no matter where the power comes from.

However, there’s a big difference between batteries and geothermal plants. It only takes a few days to install batteries, while it takes years to build geothermal plants.

Based on Professor Litman and his team’s research, for Ormat's management, the choice is obvious. That’s why since 2024, battery storage has been the firm’s biggest growth driver.

Take a look…

However, there’s a risk with Ormat’s current strategy.

Even though battery storage is ramping up, the company risks losing its competitive edge if it leans on it too much.

This is because there are only a few major geothermal players out there. Yet there are plenty of battery-storage initiatives. Everyone from energy-storage provider  Fluence Energy  to electric-vehicle giant  Tesla  has a battery segment.

Ormat currently has 350 MW of installed battery-storage capacity.  NextEra Energy —the world's largest electric utility holding company—manages over 3,600 MW of battery storage, more than 10 times the size of Ormat's fleet.

This level of competition means battery storage is less profitable than geothermal. That's part of why Ormat's Uniform ROA has fallen in recent years.

Despite this, Ormat’s management will continue installing new batteries… as long as MW generated is part of the company’s compensation plan.

Ormat will reap short-term rewards as it racks up more MW… but a focus on battery storage will limit returns in the long run.

Professor Litman says investors would realize this if they took the time to look at Ormat's DEF 14A, which details how management is paid and whether the compensation focuses on the right issues.

Geothermal is clearly the better future bet. However, the market still expects returns to skyrocket via battery storage.

The takeaway from Ormat’s story?

Taking a deep dive into how a company’s management is compensated enables you to distinguish between growth and profitability—a skill you’ll need if you want to position yourself to get ahead of other investors in any industry.

So, the next time you evaluate a stock, don’t forget to look at how its leadership team is compensated!

Hope you’ve found this week’s insights interesting and helpful.

Stay tuned for next Wednesday’s The Independent Investor!

Some shifts in the market announce themselves quietly. Others rumble beneath the surface long before anyone notices.

Learn more about  the next wave of AI technology  in next week’s article!