Proprietary Products vs. Commodity Products: Part 1

"Proprietary" is one of those words that you have to understand to get the game. People new to the business always get this wrong. Or they furrow their eyebrows or raise their shoulders and look confused. After this piece you will never be confused again.

There are two kinds of products: commodity and proprietary. Commodity is bad. Proprietary is good. Commodity is low value-added. Proprietary is high value-added. Commodity is ordinary; proprietary is specialty. Commodity is easily imitated and has no way to distinguish itself. White paper is white paper. Proprietary has a formula or some patent protection or is hard to make: gift-wrap paper.

People pay more for the stocks of companies that make proprietary products. They pay less for the stocks of companies that make commodity products. A proprietary product company generates a higher price-earnings multiple. A commodity product company sports a lower price-earnings multiple.

The stocks of commodity manufacturers trade on supply and demand of the product and have low gross margins unless the product itself is, for some reason, in short supply. Proprietary product companies' stocks don't trade with any particular commodity and have higher gross margins.

If you are making a commodity product you are not in control of your destiny: white paper. If you are making a proprietary product, let's say a drug with patent protection, you are. Once the drug comes off patent it becomes a commodity and the gross margins and profits go down. Big. Why ever own the stock of a commodity manufacturer? Great question. Periodically they get "pricing," meaning they can raise prices because of strong demand. But then more supply, more plants come on stream, and the pricing scheme drops. Estimates go up when the commodity is scarce and go down when the commodity is in supply.

So, let's put it in real terms. You are making Pentiums. You get paid a lot for them because they are proprietary and the gross margins are huge. Now you are making DRAMS. The margins are low and they are a commodity made by many companies. But the demand is so strong right now that Micron (MU:NYSE - news - boards), the biggest DRAM manufacturer, is making a fortune so people will pay up temporarily. They will not pay as much, multiple-wise, for Micron as they will for Intel (INTC:NYSE - news - boards).

But they will pay.

The trick to playing the commodity cycle is to know when it is at a trough and when it is at a peak. You can make a fortune if you time it right.

The trick to playing proprietary stocks is to buy and hold until someone makes a better, more proprietary product. If someone could make a chip better than a Pentium for much less money, you might not want to stay long Intel.

Later, in Part 2, spotting commodity bottoms and tops.

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James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long Micron and Intel. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to send comments on his column to James J. Cramer .