Highfields Capital, the hedge fund that made a fortune shorting Enron has turned its money-making sights on ready-to-eat cereal maker Ralcorp (NYSE:RAH), boosting its stake to 1.5 million shares between June and September. Should you follow, or does it make more sense to go with better-known Kellogg (NYSE:K)?

According to IBISWorld, the cereal sector is growing steadily despite economic turbulence. During the past five years, it has grown at an average rate of 3.2% and is expected to end 2011 by producing $13.3 billion in revenue — 1.9% above its 2010 level. Moreover, IBISWorld predicts the industry will grow at a 2% annual rate through 2016.

But Ralcorp is hardly the industry leader. That spot goes to Kellogg, with 34.2% of the market to Ralcorp’s 13.9%, according to IBISWorld. And Kellogg gained that lead by winning when it comes to key industry success factors such as advertising, filling up retail shelves with different varieties, and economies of scale in purchasing and manufacturing.

Ralcorp’s earnings report late Tuesday was disappointing. It lost $370 million because of a charge against goodwill related to the Post spinoff. But adjusting for that and other one-time charges, Ralcorp’s $1.34 in reported EPS was five cents a share less than the Thomson Reuters consensus estimate. The good news was that Ralcorp’s 8% sales increase for the quarter slightly met analysts’ forecasts. Investors shrugged on the news — Ralcorp stock lost 0.3% in Tuesday trading.

Kellogg’s third-quarter results were a bigger disappointment to investors. It reported a 14% decline in earnings to 80 cents a share — nine cents short of analysts’ expectations. Kellogg attributed this to supply chain investments. Meanwhile, Kellogg revenue rose 4.9% to $3.31 billion but fell $10 million short of expectations, according to ActiveInvestor.

So here’s what the investment choice between Ralcorp and Kellogg boils down to:

• Ralcorp: growing modestly, narrow margins; expensive stock. Ralcorp sales have risen 4% in the past 12 months to $4.7 billion while its net income fell 28% to $225 million — yielding a low net margin of 4.8%. Its price-to-earnings-to-growth ratio (where a PEG of 1.0 is considered fairly priced) of 1.33 is pricey on a P/E of 20 and expected earnings growth of 15.1% to $6.03 a share in fiscal year 2012.
• Kellogg: shrinking, decent margins; overpriced stock. Kellogg sales have fallen 1.4% in the past 12 months to $13 billion, while net income has soared 2.9% to $1.2 billion – yielding a decent 9.1% net profit margin. Its PEG of 3.06 is very expensive on a P/E of 15 and expected earnings growth of 4.9% to $3.54 a share in fiscal 2012.

Ralcorp is the better-tasting of these two stocks. It is still overpriced so it would only make sense to buy its shares now if you think — as Highfields may — that ConAgra (NYSE:CAG) will make a bid for the company at a higher price, after withdrawing its $94-a-share offer in September. Kellogg seems to be blundering despite its market dominance — as a result, its stock is tremendously overvalued.

If forced to pick one — I’d buy Ralcorp.

Peter Cohan has no financial interest in the securities mentioned.