In the months following the horrible attacks on September 11, 2001, U.S. intelligence experts and politicians all repeated the same mantra about what was going to happen next. “It’s not a matter of if, but when, the next terror strike will occur.”

At the time, we all believed it -- but fortunately, the experts were proven wrong, as much as three years later. On U.S. soil, at least, there were no more strikes. Might this mean that terror groups have been weakened so much that they are no longer a threat?

Maybe.

But as an investor you simply can’t take that risk. Al Qaeda has a history of waiting patiently for years between major strikes – and we may just be in another one of those holding periods.

The bottom line: If you have money in stocks, you need insurance against the sudden and dramatic downside that can ruin your portfolio in a single trading day if there is another major terror strike.

Using options can be expensive and time consuming. Taking out short positions will make you lose money if the market keeps going up. But fortunately, there is a simpler way to get your anti-terror insurance: Purchase a small group of homeland security stocks and keep them in the background in your portfolio.

These stocks will spike in the unfortunate event of another major terror strike, offsetting losses elsewhere in your portfolio. This will help you in two ways. It’ll make it easier for you to psychologically resist panic selling at the lows in the days following a terror strike. It also might help you avoid a margin call, if you borrow money to buy stocks. 

Heads in the sand

“People have had their heads in the sand, thinking we have done everything and there won’t be any more terrorism activity,” says Brian Ruttenbur, an analyst with Morgan Keegan who has taken the lead on Wall Street in researching homeland security stocks. “I think it is just a matter of time before there is more terrorist activity.” Let’s hope he is wrong. But as an investor – even if it seems crass – you do have to plan for the worst and buy a few homeland security names to put the hedge on.

What to buy? To produce a list, I’ve grouped homeland security stocks into four main categories: Identifying and tracking people, armament and protection, surveillance and monitoring, and specific threat detection and response to terror attacks. I’d suggest owning at least a name or two in each of these groups, to cover all bases.

And who knows – lots of these homeland security stocks might do well even without another terror strike. Despite all the hype, many of them actually have decent underlying businesses. Just pay attention to valuations and don’t buy at the wrong time – like during any of the frenzied rallies that periodically break out in these names. “I think people should own these stocks, because it is going to be a growth area down the road, and in the meantime it is a hedge against any terror strikes,” says Ruttenbur.

However, one tricky thing about owning these names, warns Ruttenbur, is that much of the spending that will drive them depends on politicians and government spending. This is another way of saying there’s often a shortage of actual business trends out in the real world that you can study and track as a way to select stocks. Instead, you have to follow the political process. Ugh! That can be complicated and confusing.

Next, the government spending that drives these stocks tends to be all or nothing. Either politicians are worked up about an issue and throwing money at it, or they are ignoring it. Regrettably, that takes us right back to the major terror strike as the main driver that will push many of these stocks higher.

Other Catalysts

That said, there are other major catalysts that can move these stocks -- beyond a ghoulish awareness that more terror strikes may be on the way. Here is a short list.

·     Massive U.S. federal spending Aside from defense, homeland security is the only category in the U.S. federal budget set to grow significantly. But while defense growth fluctuates based on which party is in power, the homeland security budget is more sacred – so investors don’t have this risk. And the numbers are enormous. The Department of Homeland Security (DHS) was the single largest federal department in 2004, with a budget of over $36 billion. But there are a couple of problems for homeland security investors. One is that – despite the horror of terror strikes – the DHS is woefully slow at doing its job. Years after 9/11, the DHS was still just getting its act together – and blatantly behind on several fronts. As Sen. Charles Schumer (D-NY) loves to tell anyone who will listen, around 95% of all shipping containers entering U.S. ports still go through unscreened. “The DHS has been slow in awarding funds,” agrees Ruttenbur. Unfortunately, it may take a major terrorist act to get them moving in any specific area – like those ports. “I don’t see it happening in the area of cargo containers unless there is a catalyst event,” says Ruttenbur. “We have had this situation since 9/11 and literally nothing has been done.” Bottom line: Despite the good intentions of politicians, you can’t rely on logic to help you predict where they are going to spend all that money next.

·     State spending States throughout the U.S. are busy opening up the spending spigot, too. Many are mandating stronger security features in drivers’ licenses by turning them into smart cards with embedding chips that store biometrics data.

·     Takeovers Some homeland defense companies will get a pop as take out candidates. “We believe most of the companies under our coverage have a high likelihood of being acquired,” says Ruttenbur. He thinks American Science & Engineering (ASE) and Compudyne (CDCY) are likely targets because they could provide homeland security exposure for a relatively low price. They also turn out high quality products, and they are relatively small. And they are pure plays in their sectors: X-ray inspection products, and attack-resistant doors and windows. Other companies Ruttenbur thinks may be bought out – though the chances are lower – include: ActivCard (ACTI), Drexler Technology (DRXR), Digimarc (DMRC), Identix (IDNX) and OSI Systems (OSIS). Unlikely take out candidates are: Armor Holdings (AH), FLIR Systems (FLIR), Taser International (TASR) and Verint Systems (VRNT).

·    Conferences and hearings Security stock conferences by Wall Street brokerage firms or InvestorIdeas.com, the sponsor of this web site, move these stocks. So will any major hearings on terrorism in Washington , D.C. Dramatic testimony during the September 11 Commission hearings on flaws in our security strategy served as one of the main drivers for homeland security stocks in mid-April, 2004.

·     Private spending According to a survey by The Conference Board in the summer of 2004, private companies have a lot of ground to make up in security spending. The survey of midsize companies found that half had not increased security spending at all since Sept. 11. Even more troubling, that was typical of companies in the most vulnerable sectors like transportation, finance, utilities and telecom. You can chalk it up to a sense of complacency that’s set in since 9/11, says The Conference Board’s Thomas Cavanagh. But there’s another key takeaway from his study: If there is another terror strike, the private sector could be a big source of new spending on homeland security.

When the rallies are silly, short them

One thing about stocks that get the animal spirits going -- like homeland defense names -- is that they go through brief manic phases where they skyrocket on little or no news. While shorting is not for everyone (and cannot be done in retirement accounts), consider betting against homeland defense names the next time they go bonkers for little reason. If you are a deft trader, these stocks can make profitable shorts at times like these.

For a good example, look no further than TASER (TASR), which turned into a cult stock of sorts in 2004. It changed hands for sky-high valuations in mid-April. But in the following months TASER shares got cut in half. Another example: Mace Security (MACE), a tiny company that runs car washes and offers personal security devices and surveillance equipment. In two or three days during the homeland defense stock frenzy in mid-April it briefly shot to $13 or more per share, from $3. Within weeks it had given all the gains back – making it an awesome short for anyone who noticed the rally based on little news.

To see how downright silly – and ripe for shorting – rallies in homeland security stocks can get, consider what happened in early June, 2004 with IPIX (IPIX), a small company that provides security and surveillance products. A mere, brief mention of the company in a speech by Homeland Security Secretary Tom Ridge, followed by a timely press release from IPIX highlighting the reference, sent traders into buying frenzy. They drove the stock to $13 from $8, but within days it was back below $10 per share. Another tiny security company mentioned by Ridge in the very same speech, Ortec International (ORTN.OB), did not move at all. The apparent difference? No press release.

Risks

Perhaps the biggest risk in holding homeland security stocks is you. Whenever these stocks are bid up in frenzy, there’s a chance you’ll get caught up in the hoopla and buy them before they have time to come back to earth. Better to keep a list – like the one below -- and build positions when things are quiet. No one hopes for another terror strike that will drive homeland defense stocks up. That goes without saying. But as long as another strike is likely to happen, and the rest of your portfolio will get pummeled when it does, it’s better to own some of these to offset the damage.

The List

In putting together this guide, we tried to weed out names that aren’t really homeland defense plays – despite the hype. For example, even companies like LoJack (LOJN) and MapInfo (MAPS) are brought up from time to time as homeland security plays. LoJack, because it has offered discounts on stolen vehicle recovery systems to truckers who haul hazardous materials. MapInfo, because its mapping software is used by local police. These may be good companies, but frankly, calling these two homeland defense plays is a lot of hype.

Where stocks offer exceptionally good portfolio insurance – because they react the most to terror strikes -- we point this out. To make this assessment, we examined the charts of each stock to see how much it moved up right after the major terror events of this century, including 9/11, the March 11, 2004 Madrid bombings, and the homeland defense hearings in early April 2004. (To check on stocks yourself, use the terror dates in the table.)

With that as background, here are some of the best homeland defense stocks to add to your portfolio to hedge against terror strikes.

Identifying and tracking people

One of the weaknesses exploited by 9/11 terrorists was the ability to sail right through U.S. borders and get commonplace identity documents with little notice – even though some were on terror watch lists. Thanks to this tactic, a host of companies now stand to benefit from government efforts to make it tougher to pull off this trick.

A major driver here will be the U.S. Visitor and Immigrant Status Indicator Technology (US-VISIT) program. It’s supposed to create a “virtual border” by requiring biometric identification data on entry documents like visas and passports for all foreigners. (“Biometrics” simply means the use of technology to identify people based on physical characteristics like fingerprints, irises, voices, and faces.)

The numbers here are huge. Over the next five to seven years, this program alone could produce $10 billion in spending, estimates Ruttenbur. Other drivers include a new “common access card” – a type of smart card -- for military personnel, and a similar ID card for U.S. transportation workers. There will be plenty of international opportunities, as well.

Large companies like Lockheed Martin (LMT), Computer Sciences Corporation (CSC) or Accenture (ACN) will get many of the initial U.S. contracts in this area. But the bigger winners and cleaner plays will be their subcontractors. Here’s a roundup.

Identix (IDNX)

Terror sensitivity: Very high

Product: Biometric identification systems

With its broad portfolio of products, Identix is the largest pure-play biometric company. The company sells devices like fingerprint scanners and face recognition systems.  

Cogent (COGT)

Terror sensitivity: Unknown, stock began trading in September 2004
Product: Advanced fingerprint identification systems

Cogent provides fingerprint identification systems to government and law enforcement agencies. Cogent’s Automated Fingerprint Identification Systems allow law enforcement agencies to encode fingerprints in searchable files and compare them millions of fingerprints in a database in seconds. Cogent is dependent on the Department of Homeland Security, which provides about 60% of its revenue.

International Electronics (IEIB)

Terror sensitivity: Very high

Product: Electronic access equipment

This company sells access control and digital keypad security products used to limit access to building entrances, or for the use of machinery and vehicles.

Visage (VISG)

Terror sensitivity: High

Product: Systems that produce “smart” ID cards

Visage provides systems that make identity cards using biometrics -- like driver's licenses, and national ID cards. The company also makes the FaceFINDER surveillance system -- which scans crowds to match individuals to faces stored in an image database. FaceFINDER is used by casinos, airports, military bases and the government.

Drexler Technology (DRXR)

Terror sensitivity: High

Product: Systems that produce “smart” ID cards

Drexler Technology offers systems that produce optical memory and chip-based “smart cards” which serve as identification cards.

ActivCard (ACTI)

Terror sensitivity: High

Product: Systems that produce “smart” ID cards

ActivCard provides authentication and digital identity systems for secure remote access, and access cards.

Digimarc (DMRC)

Terror sensitivity: Moderate

Product: Systems that produce “smart” ID cards

Digimarc provides secure identity cards like driver’s licenses and national ID cards. A separate division offers digital watermarking technology. Digimarc products churn out 60% of driver’s licenses in the U.S. The company also provides systems that produce national ID and voter ID cards around the globe.

ChoicePoint (CPS)

Terror sensitivity: Moderate

Product: Background checking services

ChoicePoint’s strength is high-volume, data-intensive background checks --mainly for businesses. But Citigroup Smith Barney analyst Patrick Burton thinks ChoicePoint can capture a lot of government work. The reason: Homeland security needs to call for checks on commercial drivers transporting hazardous material, or on applicants for public transport jobs.

Locateplus Holdings (LPLHA.OB)
Terror sensitivity: moderate 

Product: Database services for background checks

Thanks to a vast searchable database of personal background information, Locateplus counts the Federal Bureau of Investigation (FBI) among its clients. The FBI, for example, asked Locateplus to run cross checks of all passengers on the doomed 9/11 flights for links to terrorists. The company’s databases are also used by private companies for background checks in hiring, and banks that have to check on clients under the Patriot Act. Locateplus also distributes services through “channel partners” like Earthlink (ELNK).  

Armament and Protection  

All it will take is a car bomb outside office buildings in a U.S. city to remind us all just how vulnerable we really are. Such an unfortunate and disastrous event – or practically any other kind of terror strike or hijacking -- would drive investors to these stocks.

Compudyne (CDCY)

Terror sensitivity: High

Product: Bullet and blast resistant doors and windows

The U.S. State Department is in the midst of a multi-year plan to upgrade well over 100 embassies and consulates that do not meet security standards, for a total cost of $17.5 billion. Because it sells blast resistant doors and windows, Compudyne will benefit. The company also makes vehicle intrusion barriers, fiber optic monitoring systems to detect physical intrusion, and systems to protect secure communications networks. Its products are used in courthouses federal buildings, banks and private companies. State and local governments represent 75% of Compudyne’s overall business. 

TASER International (TASR)

Terror sensitivity: High

Product: Stun guns used by law enforcement

TASER stun guns use compressed nitrogen to propel electronic probes that lodge in victims and remain connected by wires to the weapon. The probes deliver a shot of high voltage that overwhelms electrical signals in the body, incapacitating victims. TASER weapons are used mainly in law enforcement and the military, but there are consumer versions too. Revenue growth of 150% in 2004 helped TASER achieve near cult status as a stock. But expect growth to slow going forward. The full health impact on victims who get hit by TASER voltage is still under study. But more hijackings could spark brisk purchasing of TASAR weapons by airlines, for use on board flights.

Armor Holdings (AH)

Terror sensitivity: modest

Product: Vehicle and body armor

Revenue growth in 2004 was driven in part by government contracts for armored Humvees, vehicle armoring kits, and body armor for use in Iraq . But the company also sells to domestic law enforcement agencies. With an extensive restructuring behind it, Armor stands ready to participate in the consolidation of the market for specialized equipment used by law enforcement.

Vaxgen (VXGN.PK)

Terror sensitivity: modest

Product: Vaccines against bio-terror threats like Anthrax

Vaxgen stands a good chance of being one of the main suppliers of Anthrax vaccines to the U.S. government, says Ron Garren, of the newsletter Biotech Insight. The company also has a smallpox program, and a 49% stake in a production plant in Korea . The stock was expected to get re-listed on NASDAQ in the fall of 2004.

Surveillance and monitoring

From the monitoring of mass transit systems and nuclear plants, to eavesdropping on conversations, there’s clearly a much bigger need for snooping devices in the age of terrorism. Even without the terror threat, another underlying trend should boost sales for years: The conversion to more efficient digital monitoring systems. They’re superior to analog systems because they provide better image quality, storage and playback. Less than 10% of video surveillance cameras throughout the world are digital, suggesting the potential for big sales growth.

Vicon Industries (VII)

Terror sensitivity: Very High

Product: Surveillance and security systems

Vicon Industries offers a wide variety of video surveillance systems. In mid-2004, the stock was on the buy list of value investor John Buckingham of the Al Frank Fund (VALUX), who likes the stock in part because it has a cash position worth about $1.25 per share, and a book value of $6.20 per share. This offers investors some downside protection. Buckingham thinks the stock is a buy up to $5.25.

Magal Security Systems (MAGS)

Terror sensitivity: Very high

Product: Intrusion detection systems

Magal Security sells systems which detect, locate, and identify intrusions. Magal's systems are used in more than 70 countries to protect aircraft, borders, military bases, power plants, airports and industrial sites. The Israeli government is its largest customer. Magal has provided about 80% of the electronic security for the border fence being erected between Israel and the Palestinian territories.

Digital Recorders (TBUS)

Terror sensitivity: Very high

Product: Vehicle tracking systems

Digital Recorders sells systems used to locate and monitor vehicles. Customers include government transportation departments, car rental companies, theme parks and tour operators. The company could get a boost if the DHS decides to allocate more money to mass transit systems – which may use Digital Recorders gear to track vehicles. Digital Recorders also makes audio surveillance systems.

Applied Signal Technology (APSG)

Terror sensitivity: High

Product: Equipment for monitoring communications

Applied Signal Technology offers products that collect, process and analyze communication signals on phones, the Internet, email networks, and satellite telecommunications systems. The company’s systems can search vast amounts of communications for a key word or message pattern. Applied Signal equipment is used by defense, intelligence and law enforcement agencies. When homeland defense officials announce that signs of terror plots have been picked up in the now infamous “chatter,” there’s a good chance Applied Signal equipment did the job.

I.D. Systems (IDSY)

Terror sensitivity: High 
Product: Tracking systems

Using radio frequency identification (RFID) technology, this company offers systems used to track vehicles and equipment at airports and shipyards, and inside private companies. I.D. Systems equipment is used at Newark Liberty International Airport and U.S. Navy shipyards. The company hopes both of these programs will lead to contracts with other airports and defense agencies. At airports, the wireless systems track potentially dangerous vehicles like fuel trucks, and shut them down if they are headed for the wrong place. There are as many as a million ground vehicles at airports and five million industrial vehicles in the U.S. Charging about $2,000 per vehicle, IDSY’s potential market reaches as high as $12 billion. Though it has competitors, this company looks like it has a lot of potential.

FLIR Systems (FLIR)

Terror sensitivity: High

Product: Surveillance equipment

FLIR sells thermal imaging and infrared camera systems used by the military, law enforcement and private industry. Homeland defense applications of FLIR equipment include nighttime monitoring of nuclear power plants and ports, and border patrol.

Allied Defense Group (ADG)

Terror sensitivity: High

Product: Armaments and security systems

A defense contractor, Allied Defense also has divisions which sell and install surveillance systems used by the government and private companies. This company regularly runs a backlog of business equal to its tiny market cap of around $110 million.

IPIX (IPIX)

Terror sensitivity: High

Product: Video surveillance systems

IPIX supplies video surveillance technology that has been used to monitor high profile events like the G8 Summit, the Olympics and the Super Bowl. Its 360-degree video surveillance technology allows users to see in all directions at once.

Diversified Security Solutions (DVS)

Terror sensitivity: High
Product: Security consulting services

Diversified Security Solutions offer security consulting and security surveillance systems to private companies and government agencies. The company provides security systems for Metropolitan Transportation Authority in New York. An insider made a significant purchase in the stock in June 2004 at $8.80 per share.

Image Sensing Systems (ISNS)

Terror sensitivity: High

Product: Surveillance systems

Image Sensing Systems makes video-based vehicle detection and traffic management systems used to reduce roadway congestion and monitor traffic on bridges and in tunnels.

American Building Control (ABCX)

Terror sensitivity: High

Product: Surveillance systems

American Building Control offers security and surveillance systems, access controls, and alarms for use in the industrial, governmental and consumer sectors. 

Sensytech (STST)

Terror sensitivity: High

Product: Surveillance systems

Sensytech makes a range of sensors from passive surveillance systems to airborne imaging devices used by the military and government agencies. Systems that detect minute variations in water temperature can be used to spot small boats, and high altitude monitoring systems have applications in border patrol.

Verint Systems (VRNT)

Terror sensitivity: Moderately high

Product: Wiretapping and surveillance systems

Verint provides software and systems that collect information through wiretapping and video surveillance. Customers include U.S. defense agencies, airports and private companies such as Sprint (FON), Home Depot (HD) and Target (TGT). Private companies use Verint systems to monitor stores and call centers. The company has good revenue visibility. It starts each quarter with 50% to 75% of revenue already booked. The company has around $7 in cash. Relatively new rules requiring Internet service providers to install equipment that permits wiretapping should be one source of growth.

Conolog (CNLG)
Terror sensitivity: Low

Product: National electrical grid system monitoring devices

Conolog shares don’t move much on terror events – and they won’t unless there is an attack on the nation’s power grid. But in the summer of 2004 it was at the start of a major product upgrade cycle. Conolog makes a variety of digital signal processors with military applications, but what should drive growth in 2005 is a new digital version of a device used by utilities to monitor the electricity grid. The company scored an early contract with a major U.S. utility to sell the updated version of the PDR2000 monitor in late summer, 2004. Many more contracts should follow as U.S. and foreign utilities follow the lead and upgrade to the newer version of the system.

Specific threat detection and response to terror attacks

Between 1991 and 2001, 42% of all terror strikes worldwide were carried out on rail systems or buses. Only 5% of the cargo containers entering U.S. seaports are searched. Only 30% of all cargo on passenger airlines is inspected. Astonishing numbers like these suggest there is plenty of potential business for companies that X-ray, sniff and examine packages, luggage or containers for explosives or bioterror threats. Here is a quick round up of the contenders.

American Science and Engineering (ASE)

Terror sensitivity: Very high

Product: X-ray inspection systems

While L-3 Communications (LLL) is a big supplier of X-ray inspection systems, its too much of a defense contractor to be a homeland security play. Better to go with American Science and Engineering, which also makes these systems. In addition to stationary devices, the company has a van that can be driven past containers at 15 miles an hour to scan what’s inside – good for monitoring both seaports and inner city traffic for threats.

OSI Systems (OSIS)

Terror sensitivity: Very high

Product: X-ray inspection systems and metal detectors

OSI Systems sells X-ray systems and metal detectors. It also makes devices that detect the amount of oxygen in blood, and bone density to check for osteoporosis. With $2.75 per share in cash and attractive valuation metrics following a slide in late summer, 2004, the stock was a favorite among many value managers, including Buckingham of the Al Frank Fund.

RAE Systems (RAE)

Terror sensitivity: Very high

Product: Sensors for chemical and radiation threats

RAE Systems makes chemical and nuclear detection monitors used in homeland defense and industry. In addition to day-to-day monitoring, RAE Systems devices are used by firefighters and other emergency personnel to detect radiation and hazardous material.

HiEnergy Technologies Inc (HIETE.OB)

Terror sensitivity: High

Product: Sensors for chemical and bomb threats

HiEnergy Technologies’ CarBomb Finder can perform remote deciphering of chemical formulas through steel using fast neutrons and gamma rays. The company’s technology has applications in airport security screening, bio-weapons detection, landmine detection, or the detection of erosion inside equipment used in the petrochemical industry.

Xybernaut (XYBR)

Terror sensitivity: Moderate

Product: Wearable computers

Xybernaut’s wearable computers are used mainly by airline mechanics or industrial workers who need quick, on-the-job access to check lists or technical data. But emergency rescue workers are using wearable computers to consult pre-loaded architectural plans when responding to fires at large buildings. That way, they’ll know the building layout and what materials are inside. This application makes Xybernaut a homeland defense play, of sorts.

Genencor (GCOR)

Terror sensitivity: Moderate

Product: Agents that neutralize bioterror compounds

Genencor, a biotech company serving many markets, is developing enzymes that will neutralize sarin gas and other nerve agents. The company is working with collaborators to develop sprays, foams and detergents for use by military and civilian first responders.

Spectrum Signal Processing (SSPI)

Terror sensitivity: low
Product: Software and chips used in custom radio platforms

Coming off a major restructuring, Spectrum Signal Processing should continue to improve earnings by winning contracts from the military and intelligence agencies which are converting from older radio systems to software-based platforms. Spectrum would turn into a homeland defense play if states and municipalities buy similar systems. The company believes this will happen.

Terror impact on bonds

Whenever there’s a major terror attack, not surprisingly, the spreads between low-quality and high-quality bonds widen – in the inevitable “flight to quality” by fixed income investors. But then the impact reverses over time – typically three months after the incident. This provides an opportunity for traders who act on the day of the attack or shortly thereafter, according to M. Christopher Garman, a Merrill Lynch analyst who has studied the impact of terror on the bond markets. Low quality corporate bonds tend to get hit the hardest. Bonds in the air transport, restaurant and steel sectors sell off the most. Financial services, utilities and aerospace bonds trade off the least. In one ominous conclusion in his study, Garman found that the average amount of time between major international terrorist attacks has declined over the years to one major event every five months. 

Writer: Michael Brush

Michael Brush writes a weekly market column for CNBC on MSN Money. Mr. Brush has also covered business and investing for the New York Times, Money magazine and the Economist Group. Mr. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of Lessons From the Front Line, a book offering insights on investing and the markets based on the experiences of professional money managers.

Michael Brush may hold long or short positions in any of the stocks mentioned in this article and those positions can change at any moment.