Homeland security stocks may offer some security during this period of stock market volatility, but selectivity remains essential, according to securities analysts.

Homeland security offers defensive opportunities for investors, according to Joshua Jabs, an analyst at Roth Capital Partners LLC in Newport Beach, Calif. These companies have the advantage of relying on government budgets for at least part of their funding, making them more resistant to the credit crunch that is hurting sectors ranging from consumer spending to information technology.

There are also positive trends as the US government prioritizes its needs and moves ahead with programs. As a result, there is more activity in areas such as airport security and air cargo than there was only several years ago, Jabs said.

This increased funding is combined with increased visibility of the funding’s destination. That enables investors to more accurately determine which companies will benefit and when they will do so.

Caveats

Still, there are serious constraints that require a selective approach, cautioned Steve Levenson, an analyst with Stifel Nicolaus in New York. The prices of many homeland security stocks are extremely high compared to earnings. Others do not make money and likely will never make money.

There are difficulties, as well, in investing in homeland security because many of the companies are not publicly traded, and those that are traded may be part of much larger defense companies, pointed out Tim Quillin, an analyst with Stephens Inc., based in Little Rock, Ark. Many of those that are publicly traded are relatively small and volatile companies.

With these caveats, homeland security analysts are recommending some stocks in the sector, particularly in detection, a growing field with both government and commercial applications.

OSI Systems ranks as several analysts’ top pick in the sector. OSI, based in Hawthorne, Calif., promises to benefit in particular from a new focus on profitability by management, said Quillin. In the past, the company overinvested in research and development and sales to markets that did not develop as expected. Now there is much greater awareness of the need to target those investments more carefully.

This focus on improving profitability is showing up in the company’s financial results. For the nine months ended March 31, 2008, OSI Systems reported record revenues of $451.9 million and net income of $8.3 million compared to a $23 million loss the first nine months of the previous year.

In addition to OSI Systems’ focus on improving earnings, it is also well positioned to grow, said Jabs, who also ranks the company as his top pick in the sector. It has a good backlog that provides considerable visibility for future growth. It also has been very successful introducing new technologies, such as the Advanced Technology X-ray system for use with passenger carry-on bags. The system is now being purchased by the Transportation Security Administration. The company also has good international opportunities in hold baggage and a new computed tomography offering for examining hold baggage.

American Science and Engineering (AS&E), Billerica, Mass., another detection company, is also earning recommendations from several analysts.

Part of the attraction of AS&E comes from its work in nuclear threat detection, said Levenson. AS&E is one of three companies involved in the Cargo Advanced Radiography System, a program to develop advanced detection technology for inspecting cargo.

The company has already had considerable success with other detection technologies, he said. The company’s Z Backscatter systems have been successfully deployed in Iraq and Afghanistan to screen vehicles for improvised explosive devices. Its parcel screening systems have been purchased by the US Secret Service as well as China, which will use them in the Summer Olympic Games this year.

Other sectors

Analysts see other stocks in the sector outside of detection as attractive prospects, as well.

Entrust Inc., Addison, Texas, provides digital identity and information protection. It supplies certificates for verification and encryption that are a critical element of the security technology needed for national identification cards and e-passports, said Jabs. That should position it well for future growth.

Argon ST, Fairfax, Va., and Applied Signal Technology, Sunnyvale, Calif., are both involved in signals intelligence, another attractive growth area, said Levenson. These firms provide the electronic eavesdropping equipment needed to track so-called terrorist chatter.

Axsys Technologies, Rocky Hill, Conn., is a merchant supplier of optics for night vision. The company has provided thermal cameras for the US Secure Border Initiative. It has also been involved in a Middle East border project. The proliferation of border projects and need for surveillance should put the company in a good position in the market, Levenson stated. HST

Philip Finnegan is the director of corporate analysis at the Teal Group, a firm based in Fairfax, Va., that provides strategic and market analysis to major corporations. He can be reached at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it