(FORTUNE Magazine) – For a man who has come to be seen as patron saint to capitalists everywhere, Adam Smith was oddly hard on capitalists' favorite activity--making money. "The rate of profit does not, like rent and wages, rise with the prosperity and fall with the declension of the society," Smith wrote in The Wealth of Nations. "On the contrary, it is naturally low in rich, and high in poor countries, and it is always highest in the countries which are going fastest to ruin."

In Smith's view, high profitability went hand in hand with monopoly, favoritism, trade restrictions, and stagnation. The optimal economy was a free-for-all in which consumers had lots of sellers to choose from, and workers lots of employers. That sort of vigorous competition for customers and labor, Smith figured, didn't leave much room for profit margins. Now, Smith did write this stuff way back in 1776, and the world has since become home to all sorts of economic phenomena that even the imaginative Scotsman could not have envisioned: huge multinational corporations, premium-priced fizzy brown sugar water, computer software, Regis Philbin.

Still, for the past decade or two, much of the world appears to have been taking a page from Smith's book. Trade barriers have disappeared; governments have stepped back from steering markets; industries that not long ago appeared to be stable oligopolies have been whipped into a competitive froth. Now there's the Internet, which has the potential to wipe out national borders, demolish barriers to entry in many industries, and render obsolete most of the subterfuges modern merchants use to squeeze money out of their customers. As Bill Gates put it in his 1995 book The Road Ahead--after, of course, approvingly citing Smith--the Net "will carry us into a new world of low-friction, low-overhead capitalism, in which market information will be plentiful and transaction costs low. It will be a shopper's heaven."

If we are, in fact, in a New Economy that can grow without the inflationary pressures and boom-and-bust tendencies of the past, it's mainly these Smithian trends we have to thank. But you'd think this turn of events ought to ring alarm bells for Bill Gates and anyone else running a company or investing in one. Remember, Smith didn't like profits. If we truly will be living in his world, one has to wonder: Are profits dead?

The simple answer is no: Smith saw profit as a remnant of economic inefficiency. Karl Marx famously took that view and ran with it, predicting in Das Kapital that ever-falling profit rates would bring on the collapse of capitalism. Marx, as you may have heard, was wrong. When it came to profits, so was Smith. Writing just before the Industrial Revolution, he understandably underestimated the power of technological and organizational advances to make workers more productive. In essence, economies evolve. By contributing to that evolution, businesses can keep finding ways to turn a profit, while in the static, perfectly competitive economy described by Smith, they would eventually be reduced to just breaking even.

People who talk a lot about the New Economy are usually trying to make the case that the future looks great for corporate profits and, by extension, stock prices. Much of the gushiest rhetoric surrounding the Net focuses on the purportedly boundless opportunities for profit in the virtual world. As the most cursory examination of economic theory and the historical record reveals, this just doesn't compute. Profits are not inexorably declining, but neither are they inexorably rising to the stratosphere--at least not at a faster rate than overall economic growth.

Since 1965, when U.S. corporate profits peaked at 14.6% of national income, profit growth has trailed economic growth. This makes sense; 1965 was near the end of the era when the U.S. economy least resembled the perfect competition of Adam Smith. Major industries like cars and steel were dominated by a few powerful corporations untroubled by competition from startups and foreigners. Churning out big profits was a straightforward matter of increasing market share and jacking up prices. This approach seems to have stopped working in the late 1960s, when profits began a slide that lasted a quarter-century. In the 1990s, America's CEOs finally regained their footing, pushing profits' share of national income to a 29-year high of 12.6% in 1997 (see chart). But profits were just playing catch-up. Now that they're back near the pre-1970s level, they have stalled: Profits' share of national income was down in 1998 and 1999.

Extrapolating a trend from all this data is dicey. But it's probably safe to say that profit growth will, at best, keep pace with economic growth in the coming years. If the more optimistic of the New Economists are right, the U.S. economy will continue to grow at 3% to 4% a year. This is spectacular for a big economy, disastrously slow for a growth-stock investor. Which isn't to say that some companies won't see their profits grow considerably faster. But to make that possible, others will have to see profits collapse. Figuring out which company will do what is not as easy as simply pointing to what's currently hot and what's not. Instead, it requires some understanding of where profits come from.

The most famous dissection of why Smith and Marx were wrong, and of why profits don't inexorably decline, was that of Austrian economist Joseph Schumpeter, who said that capitalist economies were constantly renewed and improved through "creative destruction." (Schumpeter thought capitalism was nonetheless doomed. But that's another story.) The most succinct account of where profits come from, however, is probably that of Frank Knight, who wrote his great work, Risk, Uncertainty, and Profit, while a graduate student at Cornell, and then went on to several decades of brilliant if mostly incomprehensible (according to former students Rose and Milton Friedman) lecturing at the University of Chicago. Knight thought all profit could be ascribed to two sources: monopoly and uncertainty. Monopoly was anything that gave an entrepreneur "control of the supply of a commodity"--a definition that encompassed dubious practices, like market corners and threats against competitors, and legitimate ones, like trademarks, patents, and even reputations. Uncertainty meant that entrepreneurs could make a profit even amid something close to perfect competition because markets moved in unpredictable ways and some people would bet right and others would not. In such cases, Knight wrote, profit is "a margin of error in calculation on the part of the nonentrepreneurs and entrepreneurs who do not force the successful entrepreneurs to pay as much for productive services as they could be forced to pay."

In other words, profit-through-uncertainty is chiefly a reward for entrepreneurs who are bold when others are timid. This should make any investor leery of buying into an industry about whose prospects everyone is exuberantly confident. The unprofitability of virtually all consumer e-commerce companies is at least partly the result of wild investor enthusiasm for these very companies in 1998 and 1999. Too many e-commerce startups got funded, and now competition is so intense that nobody can make money. Still, it's dangerous to draw investment rules out of such observations. The point is that the future is uncertain: What seems like wild enthusiasm can, after a few years, end up looking downright timid.

Of more use is the monopoly explanation of profits. This is what most of the strategy taught in business school is about: finding a way to differentiate your product from competitors' so that it becomes something unique that no one else is able to offer. The technology revolutions of the past few decades have added a new twist: If you can lock customers in to your technology and you're the market leader, profits will come pouring in. But technological change also seems to have sped up the process of creative destruction, which means such advantages may not last long.

The key is to first build a big customer base, then make it expensive, or at least a hassle, for customers to switch. Microsoft has succeeded at this, so far. So has Cisco. The online companies with the best odds of success are similarly the ones that are hard to get away from. It's easy for an individual to switch his CD-buying from CDnow to Amazon.com (or vice versa); it's a pain for a company that has moved all its purchasing to an Internet-based system designed and managed by Ariba to switch to another provider. Investors aren't blind to this--they moved in droves from consumer to business-to-business e-commerce stocks last year. But the sort of profitability that stock prices indicate customers are hoping for is destined to fall on only a few companies; that's the nature of monopoly profits.

Profits aren't subject to gravity--they don't have to fall to earth. But to keep making money, companies do have to deal with some other laws of nature: In boom times employees will demand more pay, lenders will hike interest rates, landlords will charge more rent--and the throng of competitors itching for a piece of the action will grow ever larger. That's just plain old Adam Smith capitalism. And that aspect of it, at least, has withstood the test of time.