When Stock Buybacks Are Bad

Typically when you hear of a company buying back shares of its stock, investors think, “Less supply means that future increases in demand will cause the stock’s price to rise more than it would have without the buyback.”  It’s simply a product of supply and demand at work.  While this principle holds true, it is not the only factor in determining whether a stock buyback plan is actually a positive sign for you the investor.

Fred Wilson recently highlighted why he does not favor stock buybacks in a column titled “Why I don’t like stock buybacks.”   His argument comes down to the effective use of a company’s resources (money).  Wilson targets Research in Motion (RIMM), which makes smart phones.  The company is going to start buying back shares, which Wilson sees as a bearish sign, since they’re perceived by the market as being a growth company.  Instead of expanding their product line or expanding their business in another form, they are buying back shares.  This isn’t a good long-term growth sign for a company that is supposed to be still growing.

I agree with Wilson’s analysis and general conclusions about the potential drawbacks when stock buyback programs are initiated.  Each company has a limited amount of funds and the decisions made with respect to those funds should be to make the business as successful as possible for its owners.  Growth companies buying shares of its own stock doesn’t seem to mesh well with the idea of being a growth company.