(FORTUNE Magazine) – If Wal-Mart did not exist, you can be dead sure that business school first-years would be forced to study the Target phenomenon. Nicollet Mall, Target's home base in Minneapolis, would have the kind of cult status now reserved for Bentonville, Ark.--mecca for the world's vendors. Budding retailers would dissect the Target way, its in-your-face marketing, its constant store makeovers, its surprisingly deep connection with customers. Target's size and scale would be the benchmark, not that other discounter's. The business press would trumpet Target's $48 billion in annual sales--larger than Coke's and PepsiCo's combined, nearly double Kmart's, and $5 billion greater than that of warehouse club Costco. Even in the thin profit margins of the discount store business, Target's $1.8 billion in 2003 income is countless times higher than nearly every rival chain's--and even fatter than those of five major department stores (Federated, May, Kohl's, Dillard's, and Saks) combined. And then there's Target's stock performance to consider. The company has returned a total of 603% to shareholders over the past ten years, stomping Berkshire Hathaway (up 356%) and shaming the S&P 500 (up 176%).

Rival retailers would wince with envy every time a Sarah Jessica Parker chatted up her $12.99 Target pajamas on Conan O'Brien's couch (which the style maven and Sex and the City star did before becoming a paid spokesperson for Gap). They'd ruefully wonder how it was that style editors were finding inspiration in this discount soap-and-socks retailer, how fashionistas from East Hampton and Melrose Avenue were forsaking chichi boutiques for Target's $26.99 Isaac Mizrahi fall loafers. Yes, Target would be the king of the retail mountain by any stretch of the imagination.

That Target's success has occurred in the shadow of its giant rival, however, is hardly a stain on its reputation--more like a badge of honor. Dozens of retailers have tried to challenge Wal-Mart on price over the past few decades and lost badly, ending up in bankruptcy or, worse, out of business. By contrast, Target has grown into its current position as a discount superpower by daring to be different. The company has built its reputation using a trendy assortment of distinct products, and crafted a unique approach to marketing both itself and the goods it sells. It may have only a fifth of the sales and profits of Wal-Mart, but it reels them in with ten times the panache.

But maintaining the company's status as the king of cheap chic while continuing to meet Wall Street's growth demands presents a challenge for CEO and chairman Bob Ulrich, 60, and his management team. For one thing, Target has yet to expand beyond the U.S. market. For another, if it makes the decision to grow its business aggressively in SuperTargets--discount stores with full-service groceries, similar to Wal-Mart's Super Centers--the company will be going head-to-head with its rival in the low-margin, high-risk food business.

Rather than be intimidated by Wal-Mart's heft, Target's executives take inspiration from the success of their competitors in Arkansas. Sitting in his office at Target's Minneapolis headquarters, for instance, vice chairman Gerald Storch ponders what you might call retail's Amazing Race. He pulls out the company's 2003 annual report and flips to page 26. "I discovered this once by accident," he says, and points to a column showing Target's revenue from the year before: $43.9 billion. Storch, a former McKinsey consultant, scribbles in a second sales figure right beside it: $43.9 billion. "This is Wal-Mart in 1992," he says, pointing to the second number. "This is uncanny. You could say, 'We're ten years behind.' Or you could say, 'Wow, we're the same size as the world's largest company was ten years ago!' "

As tenuous as that connection between Target now and Wal-Mart then may seem, investors have been making it for a while: Target, some believe, may be just beginning its Wal-Martian growth spurt--and may even have a steeper growth curve over the next few years than its enormous rival. Few analysts will come out and say it--but that's what the stock charts of the two companies imply. Target's stock, which of course reflects the market's expectations for the company's growth, has far outpaced Wal-Mart's over the past one, three, five, and ten years. "Target is flourishing against Wal-Mart in the same business, while almost all their competitors have either disappeared or are struggling," says Daniel Barry, a retail analyst at Merrill Lynch. Operating margins are better at Target. Same-store sales are strengthening. Its omnipresent logo has become a trademark of urban cool.

Target's secret, in fact, is that while it may be in the same general business (discount retailing) as Wal-Mart, it doesn't seem to act like it. And never did. That may help explain its phenomenal success so far. And yet that factor may ultimately be the biggest impediment to rocket-fast growth.

To understand how Target keeps its edge, it helps to examine its roots. In 1962 an already 40-year-old Minnesota retailing firm named Dayton's opened the first Target store in a suburb of Minneapolis called Roseville. The idea was, in effect, to take the best-quality merchandise of a high-end department store's "bargain basement" and sell it in a standalone shop. The discount-store model had been around for years. But Target was to be an updated, up-style retailer with prices just above the cut-raters. Target co-founder Doug Dayton says the store offered customers everything from toys and household items to artificial Christmas trees (no one believed they'd sell) and even newfangled FM radios. Eight years later Dayton's had 17 Target stores with over $200 million in sales.

But it wasn't alone. Just 62 days after the first Target opened its doors, a man in Rogers, Ark., named Sam Walton introduced a store called Wal-Mart. The folks in Minnesota hardly noticed. They were more worried about S.S. Kresge's Kmart chain, launched that same year, which was expanding fast. And there was that new low-end department store called Kohl's, in Milwaukee, which set up shop the same year (for more on retail, see "Our Malls, Ourselves").

But 1962, a year the Fed funds rate hovered under 3%, was a banner year for optimism when it came to low price points. "What Target did was figure out how to eke out a position on that [retail] landscape that was not about solely playing the cost game," says Nancy Koehn, a Harvard Business School professor and retail historian. "They went a very different direction from Wal-Mart." And pretty much everybody else. (It was a good thing: The corporate graveyard is filled with discount retailers. Many once-big names like Woolco, Ames, Bradlees, Caldor, and E.J. Korvette have closed their doors. Others, like Kmart, have struggled to come back from bankruptcy.)

From the start, Target found ways to sell style as well as steals. Even back in the 1960s, shoppers noted the company's Parisian flair by dubbing the discounter "Tar-zhay," says Laura Rowley in her recent book on the company. By 1975 it had started an ad circular for Sunday papers that was so bright and colorful it stood out from the other coupon cutters, becoming a must-read mini-style section for many. (Today Target circulates 150 million of the newspaper inserts each week.) The store's wide, squeaky-clean aisles were filled with sleek and often artful displays. In the late 1990s, Target settled on a marketing style that more closely resembled Andy Warhol--inspired pop art than the drab price-focused ads of its competitors.

But mostly Target managed to turn its shoppers into treasure hunters. Customers would race into the store to grab the Coach's Whistle teapot, a $35 gem designed by architect Michael Graves that's a cousin of the much pricier kettle he did for Italian design firm Alessi. Graves has followed up with a branded wireless keyboard, a dartboard, and poker chips. Target would license hot fashion-name brands that were suffering financially on their own--and remarket the lines to the masses. For example, after Isaac Mizrahi's financial backers pulled out from his high-priced ready-to-wear business because of poor sales in the late '90s, Target scooped him up. Now his line, from $23 multistriped sweaters to $50 sienna suede pants, is drawing style hunters to Target. (Ironically, Mizrahi's success with Target helped him launch a new line of couture clothing at tony department store Bergdorf Goodman.) The same strategy worked in bringing Californian sportswear designer Mossimo Giannulli to the heartland. His jeans are big sellers this fall.

The store has also had great success turning completely unknown brands into hits, sometimes helping the small companies market and expand their product lines. That's what it did in 2002 with Method, a tiny, environmentally friendly soap-and-detergent line out of San Francisco. Method's bright-purple hand soap and nontoxic dryer sheets now vie for shelf space with established brands like Colgate's Palmolive. "We've gone from about two to ten product lines in under two years," says Method CEO Alastair Dorward. Another successful strategy has been Target's longtime practice of teaming with high-end manufacturers to offer exclusive products to its shoppers. Sony now sells an iPod-white electronics line, from clock radios to boom boxes.

Target, of course, sometimes misses the bull's-eye. It was "too early," says Greg Duppler, a senior vice president of merchandising, on its 2001 launch of designer Philippe Starck's organic food line. "Our guest [Target's term for customer] wanted Cheerios."

But the company's style hits have clearly been outnumbering its misses. One possible reason: Target solicits everyone in the company to find the next new thing. Marketing chief Michael Francis leads a quarterly contest he calls the Big Idea. "Every team leader throws out two or three things he's thinking of--what's the next concept for food packaging or what's the next way we can reinvigorate pets?" says Francis. "We put that challenge out to the whole organization. Some people who come back with good ideas are not in the core [marketing or product development] areas. We might get someone from finance doing [ad] storyboards." Additionally, Duppler credits the company culture with institutionalizing curiosity. "Everybody is always looking for trends, from the top down," he says.

That's how Target found Andrea Immer. Three years ago a Target employee was flipping through a wine book Immer had written. He tracked down the then-34-year-old master sommelier, and within months she began selecting nearly every bottle of wine Target sells. Last year Immer helped the company launch its wine-in-a-box--or, in Tar-zhay-speak, the wine cube. Each richly colored cardboard box holds four bottles of select California wine.

But Target doesn't make its money selling designer treasures on the cheap. It makes it on diapers. On paper towels. On DVDs. Its slivers of profit come from the same kinds of things that Wal-Mart sells. The strategy is to lure its customers with a few wow-'em products and then sell them doughnuts on their way to the register.

The challenge is to know which treasures will do the trick--and equally important, to know when a hot item has run its course. On a Tuesday morning in August, doughnuts are about to get the boot. Ulrich walks into the Crystal, Minn., Target and stops at a lifeless display of Krispy Kreme cartons a few yards from the entrance. "We do extremely well with Krispy Kreme," says the CEO, dressed in a navy jacket and cowboy boots, "but frankly, I am starting to question whether it should be up here in the front. It's at every gas station and at every drugstore or 7-Eleven. I think we need to quit treating it like it's special."

Ulrich's quest to stay fresh goes beyond glazed doughnuts. His team rethinks and reworks its store designs more often than a bored housewife. "Normally, every three to four years we do a new prototype," says Ulrich, vastly enlarging the floor space devoted to one category (this year it's baby products) and shrinking another (men's clothing). In 2004, 76 of its 1,272 stores will undergo a major renovation. But one thing never changes: The company's iconic color, Target red, is everywhere. As is the famous bull's-eye.

That two-ring, red bull's-eye is just one of many weapons Target uses to grab the attention of potential customers. This year in Washington, D.C., bull's-eye-emblazoned rickshaws padded around the Jefferson Memorial tidal basin during the popular Cherry Blossom Festival. Thirty-five clones of Target's mascot, a white bull terrier named Bullseye, invaded New York City's celebrity-filled Fashion Week in February.

Target has also perfected the art of the stunt store. In 2002, the company docked a 220-foot floating shop on Manhattan's West Side filled with holiday fare. The U.S.S. Target's two-week furlough was just long enough to whet local appetites and to garner hundreds of press clips globally. A year later an Isaac Mizrahi Target boutique "popped up" for six weeks in Rockefeller Center. Then, this summer, "Deliver the Shiver" rolled through Manhattan. One of two bull's-eye-branded trucks stopped on a busy corner in the trendy SoHo neighborhood. Standing behind a red rope, in standard nightclub protocol, Target ambassadors sold air conditioners. Over a thousand of them. For $75 apiece. On Oct. 1, Target opened a temporary shop in Times Square with all the proceeds earmarked for breast cancer research. (The company gives away 5% of its pretax profits annually to charity.)

New York, New York. It's a hell of a town for buzz, it seems, despite the fact that there was, until very recently, no Target store in the city. No matter. "The buzz that generates from there has an amazing amplifying impact on our advertising budget," answers Francis. "Many may spend more than we do, but if we can harness the power of that sort of media exposure, the implication is enormous." Last year, according to Advertising Age, Sears spent $627 million, Wal-Mart $467 million, and Target $442 million on U.S. television, print, and Internet ads. Whose logo do you remember?

It's not only quirky events that give Target the allure of cool. It is also a select group of tastemakers--shoppers in key cities who morph into one-on-one marketers. (You may be one of them.) "We have a baker's dozen buzz markets," says Francis, and you probably know if you live in one. "If we can convert guests into evangelists, the credibility factor is significant. Someone else telling the Target story has far more impact than my running another consumer ad," he says.

Which brings us to the question of how Target can grow while still retaining that je ne sais quoi--that hard-to-explain quality that transforms this big-box retailer into a mass-couture Casbah. That in turn leads us to the fine balance between organic cereal and Cheerios--and how to grow a 42-year-old company.

And the fact is, Wal-Mart is so far ahead in selling cereal that it will be hard to catch up.

This battle comes to life off the Germantown Parkway in the posh Memphis suburb of Cordova. In this über--strip mall, where you can throw a baseball from a Wal-Mart Super Center and hit a SuperTarget, the two discounter's superstores are facing off.

To most shoppers SuperTargets probably look pretty similar to Wal-Mart Super Centers, except for the Starbucks inside. (Wal-Mart has McDonald's.) But while neither store is particularly busy on a hot summer morning, inside Wal-Mart, 15 of 37 checkouts are lit and active. Across the lot at SuperTarget, three of 32 registers are open.

The issue, in a nutshell, is groceries. Target has not yet figured out how to sell its brand of cheap chic in butter and lettuce, analysts say. And interestingly enough, its upscale image could be its Achilles' heel in this market. The average consumer thinks Target's Cheerios cost a lot more, says A.G. Edwards analyst Bob Buchanan. The reality is, they don't. Last March, Buchanan priced 309 items at those same two locations. Target came in 0.8% lower on a total basket-price basis. FORTUNE did its own price comparison of 17 miscellaneous items, such as a one-pound bag of Nabisco's Chips Ahoy and a box of Kraft's Thick 'N Creamy macaroni-and-cheese. Target came in $2.38 under Wal-Mart.

But the company hasn't done enough to get the message through to shoppers. One problem: It doesn't have many grocery-selling superstores to begin with--compare the 126 SuperTargets with Wal-Mart's 1,615 Super Centers--or the infrastructure that goes with them. "Wal-Mart saves a lot of money by doing its own logistics, and doing it well," says Buchanan.

Neither company breaks out numbers for its grocery business. "SuperTarget is really struggling in the Southeast and Southwest," says retail consultant Burt Flickinger III. He has just visited stores in Houston, Huntsville, Ala., and Birmingham, Ala. "They've got some of the best-looking European patisserie pastries and prime meat, but the stores are far too clinical and sterile on the food side," he says.

"The SuperTarget question, I believe, is frequently misframed," responds Storch, the vice chairman. Only a third of the stores the company plans to open are slated to be superstores, the company maintains. Target also says it is using the extra big-box outlets to woo shoppers into making more-frequent visits. (On average, shoppers visit SuperTargets at least 75% more often than regular stores.) "We survive by being clever, by being smart," says Storch. "We have no desire to copy every step that Wal-Mart has taken. If we did that, that would be a fool's errand."

The next question, then, is whether Target plans to follow Wal-Mart into international markets. Some analysts expect the company to make an acquisition abroad in the near future. But Target's CEO says he isn't rushing into anything that doesn't make sense for shareholders. "Sometimes overseas becomes a little sexy, and everyone kind of follows, like China now," says Ulrich. "We still have the opportunity at a minimum to double in size in the U.S." In fact, Target says that by 2010 it plans to have 2,010 stores--almost double the current figure.

One thing Target does want to copy is Wal-Mart's monumental growth. (Wal-Mart already has over 3,000 U.S. stores.) Can it get there? Storch certainly believes that will happen if Target keeps doing what it's doing now. "We have to keep innovating, keep being ourselves," he says. "But we don't have to invent cold fusion."