by Bob Andelman

One of the nation's biggest retailers made an art of not just beating the competition but sending it to the gallows. For a time, a senior executive at the company actually maintained a wall featuring tombstones of fallen competitors.

If you saw another company entering that industry, how would you judge whether or not it could keep its head? Should you walk away from it and look at something else?

One factor to consider is whether the market leader is still on the rise or if the sun is setting on its dominance. If service levels in its stores are deteriorating, there might be an opportunity for a competitor to step up. If a customer's experience in the store is not satisfactory or a good one, they will not come back. Retail isn't solely about offering consumers the lowest price. It's about making the customer satisfied with its business.

The Home Depot, for example, is generally revered as a great company, quite successful in penetrating the market of the professional contractor. As Lowe's comes into more metropolitan markets, it will probably shave off a percentage of Depot's warm wooly coat.

But while Lowe's is valued at half of what The Home Depot is worth, it doesn't need even 50 percent of Depot's business to be profitable.

The structure of retailing in this country is such that there is always room for a good number two after an extremely strong number one. For every Wal-Mart, there is a Target and a Kmart. A case can be made for the survival of an okay number three, although we will see whether Kmart can survive over the long haul.

It will be real hard for somebody to enter the home improvement market today with the way The Home Depot and Lowe's operate. HomeBase, once a fierce Home Depot competitor in California, is the most recent to throw in the towel, converting its stores into House2Home home decorating stores, further tightening the Home Depot/Lowe's battle.

One advantage The Home Depot holds over Lowe's is in the diversity of its concepts. Beyond its Depot store, the company has the burgeoning EXPO Design Centers, The Home Depot Special Order Center, Maintenance Warehouse and Villager's Hardware, a small neighborhood retail store concept. The idea behind Villager is that not everybody wants to spend an hour going in and out of a Home Depot megastore to buy a hammer and a box of nails.

That is the Pier 1 niche versus some mall stores. What is the advantage of Pier 1? Shoppers can park right at the front door, walk in, buy some tchotchkes and be out in five minutes.

Wal-Mart built its image on price leadership. So if you ask most consumers whether they could get a common basket of items cheaper at Wal-Mart or Dollar General or Family Dollar or Fred's or Target, their answer would probably be Wal-Mart. But when former retail analyst Craig Weichmann ran price surveys, he found out that over time, Wal-Mart had indeed raised its prices, lifting the umbrella in the industry. That permitted companies such as Dollar General and Family Dollar to be price competitive with Wal-Mart on providing basic needs for blue-collar customers. "What I learned by doing the price survey influenced which stock I recommended," Weichmann says. Dollar General soared, and then several years later, Family Dollar took off as well.

As Wal-Mart thundered down its path to number one in retailing, there were many, many stories of regional retailers that caved in because they couldn't co-exist with Wal-Mart. But certain retailers learned to adapt, finding a niche approach to the business, one in which they still fulfilled a need.

It's the same way an Ace Hardware survives in the shadow of The Home Depot.

Numbers Runners

Jack Welch, GE's revered chairman and CEO since 1981, is not interested in keeping a business unit unless it is number one, number two, or number three in its category. It is an oft-repeated position among today's business leaders.

GE is in multiple industries. That was the thing to do in the 1960s. If a conglomerate's A business went down, the B business could cover it by coming up. GE is one of the few companies still managing to do that successfully. That's because Jack Welch keeps costs down. He will kick out refrigerators if it is not number one or two in the industry. But GE is an anomaly. The way most companies win today is by focusing on whatever it is they want to do, and do it better than anyone else. A telephone company doesn't want to buy an oil company. But that doesn't apply at all to GE. It is in turbine engines, television content, television sets and light bulbs, as well as capital financing.

We could also argue that the way to grow a company is to look at the context in which it operates. Gauge the value of the broader business system. It may be the biggest player in the little sandbox that is municipal financing, but if it owns only two percent of the whole market then there is a lot of space in which to grow.

The facile argument that a company must be one, two, or three certainly applies in highly capital-intensive, fairly stable markets. But in most of the knowledge-based economies, what a business really needs is a big space to play in, with lots of service revenue.

Wal-Mart and grocery stores such as Kroger, Publix and Safeway are getting larger and building ever-bigger prototypes. With their increased size comes the power to wrestle better prices from food and beverage suppliers. But if the food and beverage companies that supply the retailers are the number one or number two player in its category, it also builds muscle power for fending off strong-arm customers. A number four supplier, however, lacks leverage to get the best shelf placement or adequate marketing, thus reinforcing its market position. So survival depends on the profitability and the cost basis of the business.

Which is more appealing to you, a company that owns a dominant market share but may not be extremely profitable, or a company that is profitable but is second or third in market share?

There is something to be said for betting your money on a strong number two, rather than a reigning number one. A number one company has all the headaches, pressures and expectations inherent with being top dog. By contrast, it is easier to fight to be number one than to actually be number one and constantly protect your turf. Let number one worry about all the problems and the issues; many number twos will gladly ride piggyback. For example, Coke and Pepsi have such a large market share that Pepsi can adequately fight with Coke on pricing, retailers, bottling relationships, things like that.

(Somewhat ironically, PepsiCo's Frito-Lay division is number one in snacks. It dominates that aisle, which gives it an advantage with retailers. Owning growth rates more than double its nearest competitor doesn't hurt either. Frito-Lay accounts for more than 60 percent of PepsiCo's sales; a big part of PepsiCo's profitability clearly rests in growth and dominance of Frito-Lay.)

For years, the soft drinks companies went after market share at the cost of profit margins, commoditizing their product. But most consumers will buy whatever liter of Coke or Pepsi is on sale that week, not differentiating between the two. We see it often in the snack aisle, where consumers will buy whatever bag of potato chips is 99 cents. They don't really care and that hurts the value behind a brand. The cereal aisle is the same way. Companies try adding value back into their brands, but following years of brutal price-cutting, it's not easy. If they don't have dominant market share and a product that consumers come into the store seeking by name, a supplier can expect tougher dealing with supermarket retailers, Wal-Mart, Kmart and Target.

A company building a niche in an industry that is completely dominated by a Microsoft-style company faces an uphill, although not impossible battle. It must demonstrate a unique relationship with distributors, a commanding manner for getting its product out, and it must perform more than adequately on inventory supply and demand. Independent consumer research data wouldn't hurt either.

A great deal depends on management. Does it understand the industry? Is it from within the industry? Does it possess good contacts within the industry? Is it ignoring reality to a fault?

Snapple carved out a unique niche in a business where it once seemed there were no niches left. There weren't many nationally marketed brands of flavored juices at the time Snapple debuted; the big soft drink companies were not yet playing in that category.

Pizza! Pizza!

Pizza Hut, based in Dallas, is a family pizza restaurant chain. It's the only one of the three industry leaders where mom, dad and the kids can sit down at a table and enjoy a pizza, salad bar, a pitcher of Pepsi and order seconds.

Dominos, headquartered in Detroit, is a pizza delivery-only chain, the only national company of its kind until recently.

Little Caesars ­ also based in Detroit ­ was a small Midwest chain that lacked restaurants or even delivery service. Its customers worked hardest to be fed, picking up the pizza themselves and carrying it back to home or office.

Pizza Hut once dominated pizza, and yet, against overwhelming odds, Domino's found a niche. It discovered Pizza Hut's Achilles' heel, and here is where smart advertising works so well. Domino's made a simple pledge and fulfilled it: delivery in 30 minutes or it's free. People took that on as a challenge. "Wait a minute! You mean I might get this product free, and Domino's will deliver my order in 30 minutes?" Domino's met the challenge and got it to the door on time a high percentage of the time. It became the exception when it didn't. Was it a better product? No. Just cardboard with some coloration on top of it, but Domino's did what it said it would do.

Just as Pizza Hut and Domino's settled in for industry dominance and an uneasy Coke/Pepsi, The Home Depot/Lowe's relationship, along came Little Caesar's which managed to poke another mile-wide niche in the pizza business. Where Pizza Hut had a stranglehold on restaurant and carryout sales, and Domino's captured the home delivery market, Little Caesar's figured if it sold two pizzas for the price of one, consumers would gladly come and pick them up. Thanks to a brilliant Cliff Freeman & Partners advertising campaign, "Pizza! Pizza!" Little Caesar's made a name for itself without dine-in locations or a delivery network.

Domino's sold convenience. Pizza Hut sold family, only delving into price on occasion. Freeman said, "We will sell price only and in a humorous fashion." He came up with the concept of "Pizza! Pizza!" ­ two pizzas for the price of one. The line, delivered by the chain's cartoonish mascot, Little Caesar, sunk in so deep that now even when Pizza Hut and Domino's advertise price, most people still think Little Caesars is cheaper.

Little Caesars built a real third brand based on humorous, price-driven advertising. Little Caesars played it straightforward ­ its 2-for-1 discount was obvious to anyone.

How effective was Freeman's campaign? Well, while Little Caesars is still No. 3 in the market after Pizza Hut and Domino's, the gap between Little Caesars and Domino's is almost non-existent. And considering the competition had a decade or two's head start, that's not bad. Little Caesars pushed the other two into straight price-oriented advertising.

In recent years, the three biggies began looking more alike as Pizza Hut and Little Caesar's each added extensive home delivery networks. Pizza Hut even opened carry-out/delivery locations that mimicked its competition's operations.

Incredibly, just when we thought we didn't need another pizza provider, a new voice rang out: Papa John's. And what was its distinction? Quality. Taste. "We will offer the market the best-tasting pizza." Not the fastest, not the most convenient. Papa John's hit the "Wow!" factor. It is now one of the nation's top 20 restaurant chains.

The lesson from the pizza wars is that a small competitor, if it does the right things right, if it can create a brand distinction in a sea of large competitor dominance, still stands a chance of breaking out.

The Lazarus Syndrome

Richard M. Frank, a former Steak and Ale veteran who was trained by Norman Brinker, was himself a legend in the restaurant business. He left his cushy job to take over a bankrupt company that bought another and then another. Today it's called CEC Entertainment, better known as Chuck E. Cheese. It was the amalgamation of Chuck E. Cheese and the old ShowBiz Pizza Time restaurants merging together. At one point in time, Frank met payroll out of his personal checking account. But in 2000, net income growth at his 360 restaurants was up 24.8 percent, to $55.8 million.

When FedEx struggled to meet payroll early on, Chairman, President and CEO Fred Smith went to his employees and said, "Would you take some stock?" They did and he persevered, building the most recognized name in overnight delivery around the world.

In 1990, William Kelley took a failing $600 million retail company called Consolidated Stores and made it respectable. Consolidated owned an oppressive inventory of third-generation stores, meaning it had unattractive locations and withered buildings that nobody else wanted. Kelley considered the assets and the market and created a new concept, Big Lots, that fit the situation perfectly. Big Lots management doesn't care what box it is in, just as long as it is cheap real estate. It sells merchandise that other people couldn't, buying it outright at steep discounts.

By the time he stepped down as chairman of the company in August 2000, Big Lots ­ as Consolidated was subsequently renamed ­ was a $4.7 billion business with 2,559 stores, including 1,308 toy stores.

Kelley learned a couple things from his previous employment. He was the number two person in one chain and he obviously didn't control the stock. The person who did control the stock sold it out from under him just as Kelley was getting up and running. Then Kelley went to another place. This time he was the number one person. But he still didn't control the board, and the board sold it out from under him. So when he moved into Consolidated Stores, he convinced the Schottenstein Family of Columbus, Ohio, to turn control over to him. He gained control of the board and the stock so that he had a platform with which he could run for daylight.

The point of these three anecdotes? There are profits beyond the obvious and usual suspects.

Value vs. Market Share

How do you define value?

Paychex, for example, is number two behind ADP in share and size, but Paychex is growing faster. It got a later start, too, so you take that into account.

But if we were sitting together 100 years ago, we would say, "What are the assets of this company?" Because what we had to choose from were telegraph, canal and railroad companies. How much they had in assets determined whether they had value or not. If the company paid a continuous flow of dividends, then it was assumed that real assets were in place and there was real value.

Fifty years ago, when the Nifty 50 ­ a group of stocks considered good buys without regard to price ­ was in place, if a company grew its earnings at a pretty rapid rate, we could make the assumption that it would pay dividends. But maybe we didn't want it to pay dividends because that slowed down the company's growth rate. We wanted to see the growth rate in earnings.

Ten years ago, if the company had a rapid revenue growth, we made the assumption that it would convert its revenue growth into earnings growth, which could then be converted into dividends. That meant that whatever its assets were, it had value.

Until the dot-com and Internet market crashed in mid-2000, if a company could increase its customer base, we assumed that it could generate revenues that would generate earnings that would pay dividends, which were based upon valuable assets.

What happened in the market over the past 100 years is that value didn't change at all. It is still what it was. What has changed is the method of detecting value. There is no other way to explain why AOL's stock price went where it went or why Yahoo's price went where it went.

When a company goes public today and its stock price takes off, it is based solely on Wall Street's expectation of its ability to generate new customers. That virtual reality would never have flown, 10, 50 or 100 years ago.

The lesson: Whatever today's metric is, it won't last.

Can You Count to One?

If a company is number one in its industry, that says that it survived all the inevitable trials and tribulations to get there. Once it is number one, number two can buy number one's product or service, examine it under a microscope, poke at it until it bleeds, discover where it can be patched and do it immediately. So much for R&D costs, right? Number one worked a long time to reach the top; number two can grab on to number one's coattails and come out immediately with a product that is a little bit better.

Netscape's free Internet browser was number one among consumers ­ by far ­ for years. Microsoft's first attempts at building its own free, competitive browser, Internet Explorer, were widely ridiculed in early versions. It froze, it was buggy, and ­ other than being conveniently pre-loaded on hundreds of thousands of new personal computers being delivered into offices and homes ­ it offered no advantages over the Netscape product. Eventually, however, a combination of Netscape stumbles, its acquisition by AOL and Explorer innovations brought parity to the marketplace. But where the products were neck-and-neck on speed, reliability and features, Microsoft's ability to fold its browser into the Windows operating system on millions of all new computers sold worldwide gave it de facto market leadership.

That is why the government doesn't like monopolies. Challenging those kinds of companies is hard if not damned impossible. The only way to do it is by challenging a narrow segment of the monopoly's business.

MBNA was once the credit card subsidiary of a bank in Maryland competing against Citicorp and American Express at the time. When it was spun out in 1991, its market share wasn't anywhere near what it is right now. But as a single-purpose company competing with diverse, larger financial institutions, it has done tremendously well.

Zenith was number one in television manufacturing for a long time. It no longer is number one. Somebody else came in, studied what Zenith produced, made a few little changes without impacting Zenith's patents and rose to the top.

Take a look at the post-deregulation telephone companies. They said, "We can't be AT&T, because they do so many things, so let's focus on the little things. Let's go after wireless, or local service, and then long-distance calls." They can provide all those services cheaper because they concentrate on them, they don't have all of the capital expenditures that AT&T went through, and they are, in fact, making a ton of money. And as you know, most telephone bills have grown since AT&T was broken up.

Analysts are split on whether your best bet is in owning the number one company in a category or a number two with a bullet and the ambition to be number one. Pick the one in which you feel the most confidence, then roll the dice.

Share the Wealth Plans

Select a leader in the space it serves, but it is also important to select companies that are in growth industries. The security software industry is an example of one experiencing tremendous growth. The industry is bifurcated. The traditional firewall market slowed to only 14 to 20 percent growth in recent years but a new market, the virtual private network (VPN) firewall opened. VPN security solutions enable secure connections not only with a corporate intranet but also with an extranet of handheld devices, portable computers, suppliers and customers. That segment of the security industry is growing at 80 to 100 percent a year.

Within that industry, most people look for a market leader, one that is gaining share within the industry. One example, suggests says F. Drake Johnstone, a research analyst for Davenport & Company LLC in Richmond, Va., is Checkpoint, which went from 31 percent market share in the 1999 firewall market to 41 percent in 2000. In the emerging VPN market, it grabbed a commanding 55 percent share.

In such a high growth market, ideally you pick the best company. But even if you don't pick the best company, the chances you will do well are certainly higher than in a slow growth industry. Checkpoint, for example, commands dominant market share and is actually gaining market share against rivals that include Cisco.

The flip side of that is the telecommunications industry. In 1999, WorldCom's revenue growth was accelerating and the future looked pretty good. AT&T and WorldCom both enjoyed lead shares in the markets they serve. But what happened? A significant change in the industry makeup, that's what. New major market interests such as Verizon entered the long distance market, and several other new major players took share as well. Instead of growing revenues, revenue growth declined for the market leaders.

Time Warner Telecom generated positive returns for investors in recent years although many other companies in its category were down significantly. The question is why? Why did that company do so well? In that sector, according to Johnstone, some local exchange carriers built up long distance fiber optic cable. Many of them did not and relied on the infrastructure of the local telephone companies. That may have been a mistake because local phone companies can delay orders and do things that mess up clients who rely on their equipment. By contrast, Time Warner Telecom, starting from scratch, built dense local fiber-optic networks in high-demand metropolitan markets, essentially ignoring the established long-distance market. As a result, 95 percent of its revenue comes from local broadband activity for other carriers and big corporations.

Not surprisingly ­ or coincidentally ­ the long distance market went to hell in a hand basket. But not for Time Warner Telecom. It controls its network and can deploy extra capacity at will quite easily, within 24 hours if necessary. Its competitive advantage is the unique focus of its business plan.

There is too much fiber in the first-tier markets, but not enough in the second-, third-, and fourth-tier markets and often not enough fiber branching in cities outside of the core urban areas. Some of the outer perimeter areas don't have enough fiber to match demand for high capacity connections. Time Warner Telecom can satisfy demand in urban areas and is also moving into some of the suburbs, capturing a huge portion of the market and providing mid-size and smaller businesses with high capacity connections.

Time Warner Telecom is a good example of a unique and defensible business model. It is also an example of a management that understands the dynamics of the marketplace.

On the Other Hand

Being number two is a constant uphill battle. It depends on valuations. In other words, for the number two player, competition can be a lot cheaper. Being number one has lots and lots and lots of advantages. Over the course of time, not being number one has some real disadvantages.

If number one is losing its edge, take another look at number two.

A mother and her well-to-do grown daughter were talking quietly during a funeral about going shopping the next day.

"Ma," the daughter said, "be prepared to spend the day."

"Why, where are we going?" the mother asked.

"To Target, Ma. We are going to Target."

"You can't spend a whole day in that store."

"I can, Ma," the daughter said, grinning.

Wal-Mart customers are loyal on price. Female Target shoppers have a deeper, more personal connection to their store, one not unlike the one men feel for The Home Depot. That's worth something extra when comparing value.

Target also gets credit for using its available capital well. Compare the market value of Target today with Sears. In a straight-up comparison, Target is extremely efficient in its use of capital. It is run by a solid management team that understands the retail sector. It is also well positioned for picking up business and locations that once belonged to Montgomery Ward.

Look at IKEA, a retail home furnishings company with an operating margin of three percent. Why would you buy that type of company? Best Buy is a company many of us shop at regularly and it is spreading out into more and more communities. It is always busy and offers great variety. But the operating margin is so thin in each store that it must sell a ton of expensive product to sustain the growth. A recession would put great stress on these low-margin, high-volume retailers of non-essential, luxury merchandise.

Early in an industry cycle may be the most opportune time to take a risk with the number two company in a market. If we are coming off of a period of high interest rates, some people buy the cheaper players because they have more leverage off of the bottom.

In 1996, Lowe's performed as well or maybe slightly better than The Home Depot. But by 1998 investors returned to The Home Depot because the multiples were better for the longer term. By that point, the multiples were too high to just play a turnaround in the economy.

In retail, we want companies that are focused on the customer. Good retail is all about customer service. That doesn't mean talking about it; we want to see it in the stores. If you're considering an investment in a retailer, you should be penalized for not spending as much time as you can in the stores. Unlike manufacturing or technology or financial services, you can sit in a retail outlet and see first hand whether the company knows its stuff.

The folks running a mid-Atlantic home improvement chain called Hechinger used to say that its main competition, The Home Depot "doesn't have a monopoly on customer service." Perhaps it does. Because by the time Depot completed its infiltration of territories in which Hechinger was once dominant, Hechinger waved the white flag and closed its doors.

Depot, and Wal-Mart too, for that matter, does not measure every transaction based on its profit and loss, but on whether the company won a customer in the process of the transaction. Did it make a customer happy today? Did it win somebody who will come back to shop in its stores in the future? Are its employees happy to work there? Is it a great place to work? Are they motivated and incented so that they will treat the customer well? Do employees have enough decision-making authority? The Home Depot is proud of the fact that its store managers really run their stores.

You could probably make as good a decision on a retail company as any analyst would by spending time in the stores. Talk to the store employees. Are they knowledgeable, respectful and motivated? Has the company invested money in training? Are customers happy or angry about their experiences? What is the signage like, inside the stores and out? How easy is it to check in and check out? That's your way of figuring, before you see the bottom line numbers, which ones work and which ones don't.

Toys 'R' Us spent the better part of the 1990s telling analysts that it was refocusing on customer service. But that was just talk and talk is cheap. Management didn't want to spend the money to do what needed to be done. When John H. Eyler Jr. joined the company as president and CEO, he set in motion the concepts to which his predecessors only paid lip service. "We will train our people, we will hire more people," he said, paraphrasing his message. "I don't care what it costs us. We will reformat the stores to serve you." The proof was in the sales. At Christmas 2000, Toys 'R' Us gained share versus Wal-Mart and Target for the first time in 10 years. And its stock more than doubled. That is not easy to do because the Toys culture wasn't built on service. So to change it, he deserves tremendous respect.

Be careful, however. Because even if the company looks great in the store, if the market is not there, it is still a dead duck. On NBC-TV's "Saturday Night Live," there was once a comedy sketch about a store called the Scotch Tape Boutique. All it sold was Scotch tape. The employees even wore plaid skirts. It was really funny and rang all too true for much of the retail industry.

What's to like about The Home Depot that's not to like about PETsMART? It's like comparing a $52 billion orange in a $400 billion orange grove with a $2.5 billion apple in a $25 billion apple grove, for one thing. It is more fun being in the $400 billion sector; it is a lot easier to do business. (SOURCE: Credit Suisse First Boston estimates of 2001 revenues.)

One of the other things we like seeing from a numerical point of view is companies that consistently re-invest in their business instead of merely exploiting opportunities for near-term profit. Bed, Bath and Beyond is doing well today because it re-invests in lower pricing, so its inventory turns are improving, and its sales per square foot are improving. But its operating margins are declining slightly because it doesn't want to get too fat. It is run by a disciplined management team that is not unlike The Home Depot's in its customer-service orientation. Systems-wise, at least one analyst says it is "probably as backwards as any company I know." But if it doesn't have the product a customer wants, it will hunt it down like a dog. That is what you want to see in retailing.

Software, Hard Share

The leading software vendors typically enjoy a higher market share in their addressed markets than you might typically see in a computer company or other parts of technology where the markets might be more fragmented.

Intel dominates its microprocessor market, of course. But it is the exception. Adobe certainly has done that, given the market leadership it enjoys in most of its markets. Microsoft dominates its markets. Microsoft dominates with Internet Explorer simply by brute force of marketing, some reasonably good technology and the ability to influence the market as Microsoft. That does not preclude some new company coming along with a decent product and carving a nice little niche for itself. But there is a difference between creating an innovative new product, which is entirely possible, versus making a successful business out of it.

One of the key issues facing Microsoft now might be losing control over platforms and screens as the computer world widens its scope from desktop PCs to the Palm, Handspring, and Web-enabled cellular phones. It is developed an antidote the company code-named "Hailstorm," but details are not yet forthcoming.

Other companies came in and created their own opportunities in these platforms, independent ­ so far ­ of Microsoft's PC dominance. They stand a good chance of being the platform or the contact point between an individual and the Internet on these devices, versus what Microsoft established on the PC.

It would have been defeatist for anyone in these new platforms to cede that ground to Microsoft. History shows us that technology changes too rapidly to ever throw up your hands and say "Never."

Going back to 1990, little Compaq took on IBM and beat it at personal computers. Dell came along with different construction and delivery methods and took share away from Compaq and so on and so forth. It has happened time and time again.

In the fast-changing whirl of technology, no rule should be accepted as set in concrete because it really depends on what the product does and what its addressable market is. Parametric Technology, a company that provides product development solutions for manufacturing, came along in the late 1980s as a start-up with a whole new way of doing design against existing vendors and trends and Parametric put them out of business. It is an example of a demonstrably superior technology succeeding in the marketplace.

As long as numbers one, two and three endeavor to stay at the top as opposed to simply coasting, coming up from below is a serious challenge to logic. But again, in technology, the new entrant phenomenon is more feasible than just about anywhere else because of the need for the next, better thing in certain markets. The markets will be receptive to it and the public is trained to drool in expectation of the new, better thing.

One thing that will continue being true is that the leaders in sectors will accrue an unfair share of the profit or the market cap associated with that sector. So for instance, there are four horsemen in the storage business: Veritas (storage software - volume management, file systems, backup); Brocade Communications Systems (fiber channel switches); EMC (large disc arrays); and Network Appliance (network attached storage appliances). Anyone in the know would be hard-pressed to declare the second most valuable company in any of their individual sectors. There is a vortex of market cap that forms around the leader. There is an increasing returns phenomenon, and if you have six good companies in a segment, each one of them will not be worth one-sixth of the market cap for that segment.

The overlay to all this is who really ends up being the thought leader, the customer leader, the technology leader of that business? And what is leadership worth?

Juniper Networks Inc. leads in the M-series Internet backbone router space; it is worth 20 times as much as Extreme Networks or Foundry Networks. Extreme and Foundry are both good companies, but Juniper is perceived as the leader. It sets the agenda for its industry.

The conventional wisdom in a sector is that the winner takes 75 percent of the profit, number two takes 20 percent of the profit, and number three through ten literally battle for the remaining five percent of the market cap and the profit in the sector. It is stunning how much more the leaders in a sector are worth.

A Tisket, A Tasket;
You Can Buy a Market Basket

A return to rational investing suggests that the time is right for buying a market basket instead of individual stocks. It's almost like a personalized, single-sector mutual fund.

Corning and JDS Uniphase were the winners in the fiberoptics business, but you could have bought that basket and done well. The smart money would buy a basket of good companies and then shift the money more toward the leaders as they emerge. That is a straightforward investing strategy, you just have to pay attention.

One of our most important signals of profitability is a market with great intrinsics, a big market, a market that spends money on its products. The data networking business is a great market because it is attached to a fundamental trend ­ building out the Internet.

Some people think that Cisco invented the data networking business. It didn't do that at all. It capitalized on it. Cisco helped innovate it. But the data networking business was human beings like us who wanted to be connected to each other on a thing called the Internet. It is bigger than any company, but there are companies that exploit it well.

Venture capitalists want a market that is rich in investment dollars, that is a big, growing market, one in which the problems are understandable by human beings. The corporate IT marketplace is a useful one. The corporate enterprise software marketplace is a useful place. The consumer information business and the consumer financial services businesses are both good businesses. There is money in those businesses. They prove to be of long-term interest to the people that are playing in them. They have long-term benefit structures to the users of those markets.

If a company has a market that can be addressed, that's a good thing. Is there a value proposition in its technology? Is it clear that it solves a problem that no one else is solving or that is an emerging important problem? Is there some advantage in the new company solving it compared to the companies that were there before it?

In the technology business, in particular, investors look for entrepreneurs who can leapfrog a technology discontinuity because they are not encumbered by their old business. Why are Brocade, Juniper, Foundry and Extreme Networks good companies? Because they took entire companies and pointed them at a technology that a Cisco or a Lucent or a Nortel couldn't get to. They were tied up in their own business.

IBM is a classic example. Sun Microsystems took a shot at IBM in workstations. Sun also took a shot at IBM in servers. Oracle took a shot at IBM in the data base business. IBM responded with a services business called IBM Global Services. There are existing businesses to which people are highly committed, and in being highly committed to those businesses and having customers, they set themselves up to be attacked in the seams by technology discontinuity.

Technology discontinuities are the enemy of large companies with existing businesses and customers because, for the most part, their resources are committed. It is hard for them to be the next best thing. Individual investors, however, look for the technology seams, the new markets, and then look for the companies in those seams that have good fundamentals.

Look for companies that have indispensable, often proprietary technology that is difficult to copy or creates a high barrier to entry by someone else. A huge lead in the marketplace, one that is essentially defensible by time or a patent portfolio or the best team on the planet doing this work doesn't hurt either.

John Hamm, a partner at Redpoint Ventures in Menlo Park, Calif., has a personal philosophy about technology that goes like this: "Companies get paid exactly as much as the difficulty of the problem they solve. This is why companies that just didn't solve hard problems over the last couple of years are now not worth much. The problems they were solving in the world just turned out not to be real hard ones."

Web services businesses such as Blue Martini Software, Viant and Razorfish once traded at $80 a share; they are all now at a fraction of that amount. The hard problem they were solving was getting companies up on the web, and it wasn't that hard, it was just scarce.

These companies jumped in with stunning revenue growth for a while, and it looked like they were going to the moon. Weren't they valuable businesses because of their revenue growth rates?

The problem is that the fundamental technology they brought to the table wasn't defensible over time. Building a PC didn't turn out to be so hard. Michael Dell won the game because he figured out that using the web and other peoples' money and leveraging Intel and Microsoft technology with vendor financing was a better business model than Gateway, Compaq or IBM's. He made good PCs, but he innovated the business in an area that was more difficult than building the PC itself. He built a better business model.

In PCs, the hard part was not building the box, the hard part was figuring out a sustainable business equation. Michael Dell's message was, "Dealers are expensive; I don't need them." Other manufacturers paid for their corporate marketing overhead with six percent coming out of their PC divisions. Dell doesn't have that bill to pay every quarter.

Leadership companies innovate in a way that makes it difficult for somebody else to catch them. It is not always the technology, made. The innovation is often based on speed ­ in production, upgrades or delivery.

The absolute hands-down winner in these businesses accrues a particularly unfair share of the profits. As long as that continues, as long as it is a slugging average business and not a batting average business, investors have reason to get out of bed every morning.

In technology industries, the top dog gets more market share, so it can generate more profits. And if it is generating more profits, it can re-invest more in R&D. And if it re-invests more . . . you get the idea. It creates a spiraling effect.

A company can buy market share, so profitability is a more important measure of success in most analysts' opinion. In the dot-com boom, companies bought market share by giving away merchandise and services. You could ask the leaders of those companies how well that worked after they ask you a question: "Do you want fries with that?"