“Homeland security is reactive,” says Tim Quillen, a senior equity analyst at investment banking firm Stephens Inc. “The stocks are hedges against bad things happening.”

One example: the underwear bomber, who was thwarted in late 2009. After that a bell weather homeland security stock OSI Systems rocketed 30 percent within a month. “The stock went on a tear,” says Brian Ruttenbur, a research analyst at Morgan Keegan. Why? OSI makes X-ray and metal detectors used to scan people, baggage and cargo that it sells worldwide. During the past 12 months ending yesterday, the stock has popped from $25 to $40, driven by border and port growth.

Much has changed, since the government spent over $20 billion beefing up airport baggage screening nationwide with X-ray devices.

Airline security is a small business: about $1 billion. There’s 2,100 airport security lanes in the U.S., and 90 percent use X-ray scanners.

“The scanners are ten plus years old now,” says Ruttenbur and “going through an upgrade cycle.” Recently, the government has ordered another 500 scanners though.

Screening cargo going on aircraft and boats at ports is also spiking. Now, only a small percentage of all cargo is scanned. Security screening will grow ten percent to 15 percent annually in coming years, says Ruttenbur in a recent report. This driver will help OSI Systems pump out strong security earnings.

Tiny Niche, Big Clout

There aren’t any pure plays within homeland security though—neither stocks or ETFs. Some players like OSI Systems sell their screening devices to healthcare companies too, so their homeland security earnings are diluted.

“You have to spread the net wide and separate reality from hype," says Quillen

Both OSI Systems and Flir Systems are undervalued right now, says Quillen.

Flir Systems is a well-managed market leader in infrared cameras used to protect critical buildings, he says. This fast-growing market is slated to expand 20 percent annually, though only half of Flir Systems’ revenue come from government business. The stock rose from $29 to $36 in the past year. And Quillen has a 12-month price target of $43 on it.

OSI Systems is another favorite. In the first quarter of the year, OSI’s security group revenues grew 27 percent over last year’s.

“The stock is a long-term play," says Jonathan Richton, an analyst at Imperial Capital, citing OSI's developing cargo scanning business. Analysts peg five-year earnings growth at 20 percent. Another plus driving earnings: OSI Systems is aggressively tightening operating margins.

A third player, American Science and Engineering makes cargo and parcel search systems. But the stock is expensive right now, say analysts, since the company missed first-quarter revenue targets.

In the past year, the stock has risen from $77 to $88. Ruttenbur expects only 4-percent earnings growth this year but 10 percent to 15 percent in the next few years, as orders pick up. His 12-month price target: $94.

For investors casting a wide net, L-3 Communications is a homeland security monolith. It’s also the sixth largest U.S. defense contractor.

The company makes surveillance equipment for airports and checkpoint scanners. “They’re playing a meaningful role,” says Quillen, “but security revenue is only about 5 percent.”



Its stock price has been flat over the last year.

These days, homeland security niche players are a safe bet though — even after the recent death of 9/11 mastermind Osama bin Laden.