Wall Street, Mean Street

"Buy the best of breed." Thus sayeth the goateed Oracle of CNBC. But what does he mean? Just how do you discern the best from the rest?

It's not that difficult, actually. Chances are, the best company sells the most stuff at the best prices, and is getting better at both. Therefore, figuring out who's the best of breed in any given industry boils down to figuring out who:

• Makes the most profits, and
• Is growing those profits the fastest.

Let's take a familiar example. Most of us drive cars, and all of us know who the major car makers are. So open up your favorite financial data site and find information on each company's net profit margin and projected growth rate. For the "Big 6" automakers, the results should look something like this:

Creating a simple chart like this should quickly reveal to you which car maker is best of breed -- today. (And in this example, it's clearly Toyota, which makes the most profits today and has proved itself the fastest profits grower of the bunch.)

But what about tomorrow?
Good question. As long-term investors, what we're really interested in is not who's made other investors the most money in the past, but who will make us the most money in the future. And while that may very well be Toyota today, it's not necessarily true going forward.

Just take a look at what Professor Aswath Damodaran of the Stern School of Business at NYU has to say about growth rates. Quoting from his classic text, Investment Fables:

Earnings growth rates at firms tend to revert to the average for the market. In other words, companies that are growing fast will see their growth rates decline toward the market average, whereas below-average-growth companies will see their growth rates increase.

The process Damodaran describes is commonly called reversion to the mean. Simply put, over time, the difference between good companies and bad companies contracts, and they meet in the middle.

This is logical if you think about stocks not as the tickers you trade, but as the businesses they represent. Say Company A has a great product that consumers love. Sales and profits soar, and it's growing like gangbusters. Eventually, Company B gets jealous and decides to imitate A. Then Companies C & D join in as well. They all start eating into A's market share, forcing A to accept lower profits to defend its market share, and presto-change-o, the whole "industry" winds up at the same growth rate. From A's perspective, its rate has reverted to the mean.

Imitation is the sincerest form of competition
You see this all the time in business. In the car world, the success of Honda's Insight hybrid car helped spur Toyota to sell its Prius in the United States, then for Nissan, Ford, and GM to develop their own hybrid contenders. In consumer electronics, Apple Computer's (NASDAQ:AAPL) runaway success with the iPod soon had Samsung, Gateway (NYSE:GTW), and Verizon (NYSE:VZ) knocking at its door.

In the first case, Toyota's Prius conducted a corporate hit-and-run on Honda, quickly knocking the leader off stride and making Toyota king of the hybrid hill. In Apple's case, the trendy computer maker has so far fended off all comers.

But you can bet the rivals will keep coming at Apple. And I doubt Honda will sit still and quietly allow Toyota to remain hybrid kingpin. For that matter, Ford and GM are making serious efforts to become car-making contenders once more. My point here is that business is dynamic, and best of breed is a temporal phenomenon that's subject to change.

Which is why, at Motley Fool Stock Advisor, we practice business-focused investing. Rather than fixating on a stock's label as best of breed, or becoming enamored of (or frightened by) its stock performance, we drill down to what's going on at the business that stock represents. We strive to:

• Buy companies that dominate their market niches today.
• Buy them at reasonable prices to guard against future reversals of fortune.
• Constantly monitor their performance to ensure they are defending and widening their "business moat" against competitors.

To date, our focus on companies -- not stocks -- has given our subscribers a market-trouncing return of 60% versus 21% for the S&P 500. And we have no intention of reverting to the mean. Join us -- click here now.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. If he did, The Motley Fool would require him to tell you so. We're sticklers about things likethat.