In 1931, the Davis brothers founded a small grocery store chain in southern Florida using a $10,000 bank loan and starting with just a handful of locations. Within two decades that tiny chain had expanded via a series of acquisitions and new store openings across the southern U.S. and became one of the nation's largest food retailers. The stock listed on the prestigious New York Stock Exchange (NYSE) in 1952.

But this chain of grocery stores, which came to be known as Winn-Dixie, fell on hard times in the 1990s, facing slumping same-store sales growth and declining customer traffic. Despite several attempts to cut costs and boost margins, one of the oldest and largest American supermarket chains was forced to file for Chapter 11 bankruptcy protection in 2005.

So, why the sad story? The fact is that the Winn-Dixie story is just a microcosm of much larger, longer-term changes that have taken place in the U.S. grocery retail industry over the past 20 years. While some longstanding chains like Winn-Dixie and Kroger (KR) have found it difficult to compete in this century's rapidly changing retail environment, others have found the secret to success and are flourishing. A handful of these modern supermarket mavens will continue to pick up market share and see accelerating growth in this new era of retail competition.

Winn Dixie's main problem is simple: the world's largest retailer, Wal-Mart Stores (WMT). Wal-Mart entered the food retailing business in the late 1980s when it opened up its first massive Wal-Mart Supercenter store. Each of these locations now features a full line of grocery offerings, including fresh fruits and vegetables, meat and household goods. A little over a decade later, the company had expanded its grocery store format nationwide, upgrading existing Wal-Mart locations into the larger Supercenter format. And by the end of the 1990s, the firm had quickly become the nation's largest grocery retailer.

With more than $300 billion in annual sales, Wal-Mart is truly a behemoth. The company can afford to negotiate ultra-low prices from suppliers because it's far and away the largest buyer in the country for most types of goods. In addition, Wal-Mart has a huge low-cost distribution network in-house, so it doesn't have to rely on expensive third-party distributors. This helped the company to quickly offer the lowest-cost groceries anywhere in the country. In fact, Wal-Mart is such a cost leader that it is often able to sell food on a retail basis at a lower cost than most small stores get at the wholesale level.

In addition, the company often uses grocery offerings as loss leaders. In other words, many consumers frequently visit their local Wal-Mart to purchase low-cost food items. Wal-Mart benefits from these repeat visits, as that increased foot traffic results in sales of the company's other goods. The boost in store traffic usually more than makes up for any money Wal-Mart might lose on some of its grocery items.

Supermarket chains that have tried to compete head-on with Wal-Mart on price have failed miserably. Although Winn-Dixie was a large company, it simply didn't have the buying power that Wal-Mart enjoys. As such, the company could not profitably offer prices that compete with Wal-Mart.

Other big-name grocery retailers like Safeway (SWY) have experienced similar problems. In addition, these companies do not have large lines of non-grocery offerings. As such, traditional grocery stores cannot afford to lose money when selling food just to attract more customers to their stores.

But just because Wal-Mart is a fierce competitor does not mean that other companies can't earn impressive profits in this market. Competing head-to-head in price has not been a successful strategy, but there are other ways to differentiate and create a competitive advantage. One of the most successful has been the high-end grocery chain.

Specifically, Wal-Mart competes almost exclusively on price. Wal-Mart's stores are similar to giant warehouses and are not designed to offer the same shopping experience as a traditional market. Meanwhile, although its fruits, produce, and meats are cheap, they are not necessarily of the highest quality. And certainly, Wal-Mart sells very little in the way of organic and specialty meats -- these items tend to be expensive and difficult to source in bulk quantities.

High-End Grocery Chains -- An Underserved (and Growing) Market Niche
Americans have grown increasingly health conscious in recent years. Market research shows that consumers are turning to organic and other healthy natural foods even though such foods generally sell for premium prices. For example, sales of organic fruits and vegetables soared from just $500 million in 1990 to more than $2 billion a decade later.

And according to the Organic Trade Association, total organic food sales were $10.4 billion in 2003 and should grow to more than $32 billion by 2009. While the market for traditional groceries is mature and is growing at just +2% to +3% annually, the market for organic foods is expanding at a near +20% clip.

A handful of retailers are capitalizing on the trend towards eating more health-conscious and high-quality goods. Rather than compete with Wal-Mart on price, these firms are selling premium products at premium prices. As a result, these high-end organic chains are delivering profit margins as much as double those posted by traditional chains.

In addition to product quality, there are other ways to compete with Wal-Mart. Here's a rundown of a few of the strategies currently employed by the nation's most successful grocery retailers:

Location and Convenience -- Most of Wal-Mart's locations are outside cities and in rural areas. Many consumers find it difficult to travel to a Wal-Mart to go shopping and are willing to pay a higher price for the convenience of a local store.

In-store cafes, bakeries and deli counters -- While Wal-Mart sometimes offers fast-food style restaurants in its Supercenters, it doesn't offer items like freshly-baked bread and premium coffee. These restaurant-style offerings have proven effective when it comes to attracting consumers to stores.

Warehouse Clubs -- While competing with Wal-Mart on price is rarely a winning strategy, a handful of so-called "warehouse clubs" have been able to offer pricing on groceries that is competitive with Wal-Mart. Most of these stores are clubs that charge an annual membership fee to use their stores. In addition, they sell other non-grocery items that carry higher margins than food.

By finding the companies that are able to beat Wal-Mart in these areas, investors are likely to find securities that will allow them to cash in on the new trend in the grocery industry.

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