Food stocks -- the shares of the companies that manufacture, distribute and sell food -- are a traditional haven in risky stock markets and uncertain economies. The logic is simple: No matter what, people have to eat.

But the bear market of the last two and a half years has trashed traditional wisdom. Remember the idea that dividend-rich utility stocks were safe? Try convincing anyone who owned shares of

Duke Energy

(DUK) - Get Report

, down about 50% this year.

Likewise, investing in food stocks isn't so simple, or so safe, anymore. Thanks to revolutionary changes in the industry, food stocks in general are both more risky and more potentially rewarding now than they've been in other periods of market turmoil. The trick is to separate the stocks that are being punished by these changes from those that are benefiting from them. That last group still offers the traditional safety of the sector but now promises higher returns as well.

Two Developing Trends

Here's how I'd go about separating the risky from the rewarding. Two major trends are determining winners and losers in the food sector right now.

Trend No. 1: Relentless pressure on profit margins

This is brought on by the increasing size of the industry's distribution and sales companies. I don't think you can underestimate the importance of the Wal-Marting of the retail food industry that began about 14 years ago.

Wal-Mart Stores

(WMT) - Get Report

is now the largest grocer in the country by sales, with food revenue of $65 billion, $15 billion more than No. 2

Kroger

(KR) - Get Report

Wal-Mart's share doesn't even include the $18 billion in sales made by the company's Sam's Club warehouse division. By itself, the Sam's Club unit is the eighth-largest grocer in the country. Together, the two pieces give Wal-Mart better than 12% of the grocery market, and its share is growing at the expense of traditional grocery chains such as Giant Eagle (less than 1% of the national market) and

Great Atlantic & Pacific Tea Company

( GAP), known as A&P (less than 2%).

Costco Wholesale

(COST) - Get Report

, another warehouse grocery retailer, now No. 7, has a larger market share, at 3%, than either A&P or Giant.

But Wal-Mart hasn't just created competitive woes for other grocery stores. The company uses its massive market presence to negotiate lower prices with suppliers. Then it passes heavy savings to consumers, who then increase Wal-Mart's sales, giving the company even more clout with suppliers. This cycle of events cuts profit margins for all food companies.

Trend No. 2: Vertical integration

Tyson Foods

(TSN) - Get Report

for example, hasn't been content to remain just a grower and processor of chicken for branded food companies. Instead, Tyson has moved to create its own Tyson brand -- both for raw chickens and for value-added products such as chicken nuggets, frozen fried chicken and frozen prepared chicken dinners. Why let other companies enjoy all the biggest markups?

Other long-anonymous producers of raw foods have followed the same course.

Smithfield Foods

(SFD)

, for example, does everything from raising hogs to producing branded pork chops. In the fresh-produce sector, companies such as

Dole Food

(DOL) - Get Report

and

Performance Food Group

(PFGC) - Get Report

have moved from simply distributing lettuce and fresh fruit to creating branded prepared salads and pre-sliced packaged fresh fruit.

The two trends aren't unrelated. With profit margins under pressure from huge distributors such as Wal-Mart and

Sysco

(SYY) - Get Report

food producers have seen vertical integration and the creation of value-added brands as a way to capture a greater share of the food dollar. And everyone, from distributors to vertical integrators to commodity producers, is fighting to get bigger so that they can spread fixed costs over a larger volume of business. It's acquire or be acquired.

ConAgra: Up to the Challenge?

I don't think there's anything particularly secret about these trends. CEOs don't have to be even junior rocket scientists to see how the food business is evolving. And the trends have been visible for a decade or more. That's plenty of time for even the slowest company management to grasp the big picture.

But just because a company sees the strategic challenge doesn't mean it can meet it. For one thing, companies begin the effort with very different sets of strategic assets. And some asset mixes are simply better suited to meeting the current challenge than others.

ConAgra Foods

(CAG) - Get Report

, for example, clearly recognizes the challenge it faces and has begun to respond. The company has long shown a meager 4.3% return on assets, well below the industry's 6.2%. A large part of the problem: 25% of company sales come from the low-margin, red-meat processing business. Just this month, though, ConAgra closed a deal to sell that business to a joint venture co-owned by ConAgra and Hicks, Muse. That deal should raise ConAgra's return on assets. And with the cash, the company should be able to pay down debt and improve its credit rating.

But the sale of the red-meat part of the business is only a first step. ConAgra still owns low-margin poultry and commodity-products businesses -- operations it plans to shed. At that point, the company will have to create a viable growth strategy. ConAgra owns an attractive mix of consumer brands -- Healthy Choice, Chef Boyardee and Swiss Miss, for example. But compared to the segment's leaders, Nestle and

Kraft Foods

( KFT)), the ConAgra brands represent an extremely modest market presence. And with a debt-to-equity ratio of 1.33 (before the sale of the meat processing business), ConAgra's ability to grow by acquisition seems limited.

Smithfield: Creating a Market for Branded Meat

Contrast ConAgra's situation with the challenges of Smithfield Foods. The company has sought to grow beyond its traditional pork business by acquisition, acquiring beef companies Packerland and Moyer in 2001. The larger Smithfield can now spread fixed costs over a larger base of sales; it's now the fourth-largest beef processor in the country, with a 9% market share.

At the same time, Smithfield is attempting to improve profit margins by increasing its sales of branded meat products. Fortunately for Smithfield, it doesn't have to confront the competitive challenges of a Kraft or a Nestle. Rather, its major competition comes from Tyson and

Hormel Foods

(HRL) - Get Report

. The meat industry is in rapid consolidation, and that means acquisition candidates are plentiful for a company with Smithfield's relatively modest debt load. The company has, in fact, told Wall Street to expect another deal this year.

But the really tough battle is to create a market for branded meat in the first place. By and large, such a market hasn't existed outside of chicken, where Perdue has led the charge. So consumers have to be convinced, pretty much from scratch, that it's worth spending the extra money for Smithfield meat or Smithfield value-added processed meat product. Category creation is tough anytime, but it's especially difficult when a dicey economy has made some consumers price-sensitive, and when other producers are willing to sell their commodity meat products at far lower prices.

In the short run, at least, Smithfield stock looks as though it will remain extremely sensitive to commodity prices of pork and beef. And with pork supplies running high, that's likely to keep short-term results at Smithfield under pressure. This is a stock that's worth buying if you believe in the long-term success of its value-added marketing. But in the short run, it might not provide the safety that investors expect from a food stock in a volatile market.

Performance Food: A Safer Food Stock

So where does an investor look for the traditional safety and the potential for higher returns that the revolution in the food industry has created?

Well, how about at companies that are operating in fragmented parts of the food sector -- ones that avoid going head to head with a Kraft or Nestle, but where the consumer has already been convinced to pay higher prices for a brand or a convenience?

Consider, for instance, Performance Food Group, a food service distributor and competitor of Sysco, which is a recent Jubak's Pick. Going head to head against Sysco wouldn't be a picnic. But the food-service distribution sector is still so fragmented that this kind of competition is a long way off. Performance Food Group remains primarily a regional company concentrated on the East Coast. Its national expansion has only just begun. Sysco, meantime, is the largest company in the sector, yet it has only 12% of the market. About 2,500 companies split up 70% of the market. Performance Food Group has about 2%.

In October 2001, Performance Food Group bought Fresh Express, a market leader in the fresh prepared-salad market, a value-added segment with a proven record already. Fresh-cut produce made up about 60% operating profit in the second quarter of 2002.

But that's really just the start. The company is now running product tests in stores on a line of fresh-cut fruit products. Packaged in various portions, the products offer fresh-fruit medleys (preservative-free) of different combinations of melons, watermelon, apples and oranges already washed, peeled and sliced. The items come in freshness-dated clear packaging. At the moment, the retail fresh-fruit market is worth about $16 billion, and the fresh-cut-fruit segment of that comes to just 2%.

Here, Performance Food Group's relatively modest size -- compared with a Sysco, for example -- actually becomes a plus. With revenue of just $4 billion for the last 12 months versus Sysco's $23 billion, Performance Food Group doesn't have to hit a home run with its fresh-fruit product in order to see a significant contribution to growth from the new line.

With Performance Food Group, I think investors still get the traditional safety of the food sector but also gain a chance to profit from the changes in that industry. At least that's how I'd tweak the traditional search for safety in food stocks for this very volatile and uncertain market. I'm adding Performance Food Group to Jubak's Picks with a target price of $37 a share by March 2003.

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.