(FORTUNE Magazine) – The videogame industry is blasting its way back from a two-year slump. Videogame software sales, including those for PCs, are expected to take off this Christmas and beyond (see chart) as next-generation machines, such as the Sony PlayStation and the Nintendo-64, begin to offset the decline of older consoles. But promising as the overall market looks, investors must be selective about how they choose to play. A shakeout is under way among the software companies struggling through the transition from 16-bit to more powerful 32-bit (PlayStation) and 64-bit (N-64) systems. Because there are too many companies vying for limited shelf space, the industry is entering a Pac-man-like phase--every player is either gobbling up competitors or being gobbled.

In this environment, analysts think Electronic Arts (ERTS, Nasdaq), Activision (ATVI, Nasdaq), and Midway Games (MWY, NYSE) are among the best positioned. Activision CEO Bobby Kotick recommends, "If you want to evaluate who is successful, go to a store and look at who is on the shelf."

One name that should not be hard to spot is Electronic Arts. The San Mateo, California, company sells more sports titles, including the evergreen John Madden Football series, than any other company. With $532 million in revenues and profits of $41 million for the fiscal year ended last March, this global distributor can easily flex its muscles. Its $36 stock reflects that power, trading at about 30 times the 1997 earnings estimates reported by First Call--a premium to its peers.

Alex. Brown & Sons analyst Larry Marcus thinks this premium is more than deserved because Electronic Arts is focusing on developing games for the PC and PlayStation. Marcus says, "The secret to getting revenues is to have hit titles and be on the right platform." A third of all videogames sold are played on PCs. And publishing CD-ROM-based games for the PlayStation is more lucrative than producing cartridge games for the N-64. Cartridges pose higher inventory risks because they are three times as expensive to make.

Activision is pursuing a similar PC-PlayStation strategy. And like Electronic Arts, it builds franchises out of hit titles, producing sequels such as MechWarrior 2: Mercenaries, which appeal to the original game's devotees. With a strong lineup for Christmas, its $12 shares would make good stocking stuffers. Profits in the fiscal year ended last March were $5.5 million, on revenues of $61 million.

Five years ago Activision CEO Kotick and his partners, including casino tycoon Steve Wynn, bought a controlling interest in the Los Angeles company. Its market cap then was a mere $2 million; today it stands at $175 million. Kotick culls titles from Activision's extensive library, filled with old Atari hits, and updates them--the distribution network and brand recognition from the Atari days are still intact.

Another old standby is Midway, recently spun off from WMS Industries at $20 a share. The Chicago company is responsible for such arcade classics as Space Invaders, Pac-man, and Mortal Kombat. Last year it stopped licensing rights to its coin-operated games and started producing its own home versions. "A hit in the arcade is guaranteed to be a smash in the home market," says CEO Neil Nicastro. Since the company already knows which titles will be hits, it can afford, with $329 million in revenues, to make cartridge games for the N-64, where fewer competitors means more pie for Midway to munch.