When a respected company hits a pocket of air during mid-flight, everyone notices. A sharp drop in the share price and future expectations occurs, alongside a sharp rise in the stomachs of shareholders and people who nearly bought the stock before the plunge. "I could have been on that one," people murmur, thoughtfully shaking their heads. But amidst our private near misses and public disbelief, not many of us think to short the crestfallen company.

As a refresher, shorting a company is when you sell shares of stock that you don't own (you borrow the shares from a broker) in hopes that you can buy the shares back at a lower price. You then pocket the difference. If the stock rises sharply, you can lose your shirt.

The Rule Breaker Portfolio has shorted some big names before. Quarterdeck was a big name in 1996. The portfolio shorted the software company because its financials and its management were suspect, not to mention its products. The stock was sold short at around $8 per share. We covered the short, meaning we bought back the shares to return to the broker, at about $4 per share, pocketing a 50% gain. If we'd waited, we could have bought the shares at $2.

Soon after, we shorted Trump Hotels and Casino Resorts (NYSE: DJT) at about $8 per share. We covered that around $4, too. Now it's $2. Trump Hotels has $1.8 billion debt and lacks net income. 

Now, the potential short that we're about to discuss has a strong balance sheet, was recently profitable, and is in a promising industry. So, it isn't an ideal short, but the prospect is interesting nonetheless, and since shorting can be devilishly fun, we're trying on different ideas for size.

Try on Palm Inc. (Nasdaq: PALM): Seller of the famous PalmPilot handheld computer; top dog and first mover in an important, emerging industry; also, apparently, first to stumble. Palm recently announced that it would liquidate $200 million in aged inventory because the product was not likely to sell at normal prices. It is outdated. Handspring's (Nasdaq: HAND) more versatile and less costly handheld computers are stealing market share, while Palm's new models, due by June, are tempering demand for existing Palm models. Also, Palm says, demand has simply slowed.

Whatever the reasons, $200 million in inventory is a giant pile of clams when you only had $460 million in sales last quarter, and when you expect only $300 million in sales for the current quarter. The retail channel is full of Palm products and now Palm is forced to eat them. Did management have its head in the sand? How often does it do retail channel checks? Didn't it know that product was piling up? 

If Palm is like Handspring, it may not be entirely at fault. Once Handspring has a product order in the queue three months from mass production, it is basically unable to cancel the order. Those puppies are going to be made even if they're going straight to the pound (sorry for the sad metaphor --- I love animals, too).

Either way, whether the inventory glut is due to poor management or not, Palm's management is still a shell of its former self. The three founders of Palm -- the man who created the PalmPilot, the woman who built Palm Inc. from the ground up, and the man who marketed the PalmPilot as it became the fastest-selling electronic product in history -- all bolted to start Handspring. It is estimated that 75% of Palm's original technical engineers bolted Palm to join Handspring, too. Seventy-five percent!

So is it any wonder that since late 1999 -- when Handspring launched its first product, the Visor, which can become a phone, MP3 player, camera, and more -- PalmPilots haven't advanced much at all? PalmPilots are still basically the same old organizer with capability that only expands by loading extra software. Only in the upcoming new models (the "m" series) do PalmPilots begin to offer expansion in ways that Handspring has offered for eighteen months. The thing is, Handspring will have its next generation product on shelves before too long, and that product could once again leapfrog Palm in functionality and price.

Numbers show Handspring's early acceptance. The company has quickly gone from a big zero to 26% market share. Palm's market share has gone from about 86% to about 60% since October 1999 when Visor launched. Though from a smaller base, Handspring's sales are increasing while Palm's have recently declined.  

             Quarterly Sales (in millions)

             Handspring   Palm
Q2 00        $15.7        $258.5 
Q3 00        $34.3        $272.2
Q4 00        $51.8        $350.2
Q1 01        $70.5        $400.9
Q2 01       $115.6        $522.1
Q3 01       $123.8        $470.8
Q4 01 est.* $130          $307
FY 01 est.* $440 $1,700
FY 02 est.* $657 $2,000
* estimated sales

From my perspective, Handspring is innovating and moving quickly. It is building a differentiated brand that stands for leadership. And sure, Handspring isn't immune to a demand slowdown, but it has much less inventory than Palm. Also, early Palm enthusiasts know that Handspring has the Palm inventors at its helm. Given that, many are buying Handspring products and recommending them to friends who are new to the industry. (Finally, note: Handspring isn't beholden to the Palm Operating System, as most believe. Handspring chairman Jeff Hawkins states that eventually Handspring will offer other operating systems, including perhaps its own, but it has rights to Palm's software, too, until 2009. That's a potential win-win.)

In contrast, I see Palm as slow to innovate, stuck with mountains of inventory, and -- most importantly -- as being run by a management that inherited someone else's aging idea. Do Palm managers have a vision for the handheld computer industry the way that Handspring's chairman does? I don't see reasons to believe so. So far, they've seemingly just copied his ideas.

At a current $8.40 per share, Palm is valued at $4.7 billion. After briefly making money, it is now losing it again. Clearly this column is just step one. We need much more analysis before we'd short Palm. But it's a thought. So, am I whacked in the head, or what? Would shorting Palm be a big mistake? Please share your thoughts.

Jeff Fischer does not own shares in any of companies mentioned, but remember, he might be "whacked in the head." The Motley Fool has a full disclosure policy.