War is big business, and business is booming -- in the Middle East.

JDAM delivery. Image source: Boeing.

Since the terrorist attacks in Paris last Friday, U.S. defense stocks have been on a tear. The popular iShares U.S. Aerospace & Defense ETF (NYSEMKT:ITA), for example, was up nearly 3% by midweek, while some individual defense stocks, such as Boeing (NYSE:BA) and Raytheon (NYSE:RTN), did even better -- up 3.5% and 5%, respectively.

Why these stocks in particular? To guess the answer, you need to understand how the war against ISIS is being fought.

No boots on the ground
The guiding principle in the way the West (and its allies) are fighting the ground war against ISIS in Syria and Iraq today is that... they aren't. Fighting on the ground, that is.

Instead, President Obama has stated on multiple occasions that he has no intention of putting American "boots on the ground" in Syria. Other countries are in no rush to do so, either. As a result, the fight against ISIS today is very much an air war. It's a war being waged not with tanks and armored personnel carriers, but with aircraft -- and more specifically, with bombs and missiles dropped from aircraft.

From an investing perspective, this means the companies facilitating (and profiting from) the fight against ISIS today are the companies that make the bombs and the missiles. To an extent, the companies that make the aircraft themselves can be considered viable investments as well. But because aircraft are reusable, and bombs and missiles are not, most money being spent on fighting ISIS is being spent to buy ordnance (bombs), and not ordnance delivery systems (bombers).

And this explains why it's the bomb and missile makers' stocks that are moving.

SDB before impact. Image source: Boeing.

Which stocks in particular?
This very week, we saw further evidence of why these stocks are moving when Saudi Arabia, an ally in the war against ISIS, and at the same time a country involved in an additional war, requested permission from the U.S. Congress to purchase an immense number of air-to-ground bombs from U.S. defense contractors.

The order, which runs to just under 22,000 pieces of ordnance in size, breaks down as follows:

  • 8,020 BLU-111/MK-82 500 lb "general purpose" bombs
  • 2,300 BLU-117/MK-84 2,000 lb GP bombs
  • 4,020 GBU-12 Paveway II Laser Guided Bombs (LGBs)
  • 2,000 GBU-48 Enhanced Paveway II LGBs
  • 2,000 BLU-110/MK-83 1,000 lb GP Bombs
  • 1,500 BLU-109 2,000 lb Penetrator Warheads (used for attacking hardened targets)
  • 1,000 GBU-10 Paveway II LGBs
  • 1,100 GBU-24 Paveway III LGBs

Additionally, Saudi Arabia is buying 5,200 assorted JDAM (joint direct attack munition) guidance kits for conversion of some of the above dumb bombs into "smart bombs," and also 10,200 FMU-152 fuzes, which tell a bomb how far from its target to explode, and whether to explode on impact or penetrate a target first and explode later.

The total cost of the 21,940 bombs Saudi Arabia is buying, plus various add-on equipment, works out to $1.3 billion according to the U.S. Defense Security Cooperation Agency. And that averages out to $58,800 per bomb dropped.

Who makes all this stuff?
Unsurprisingly, the same companies that make a lot of the above ordnance are the same stocks that began moving last Friday. Raytheon makes export versions of the Paveway II laser guided smart bomb, for example. Boeing builds the low-cost guidance kits that are known as JDAM.

Two companies whose stocks have yet to move, interestingly -- but that might once investors get a firmer handle on what's going on -- are Kaman Corp (NYSE:KAMN), which makes the FMU-152 fuzes mentioned above, and General Dynamics (NYSE:GD), the contractor responsible for manufacturing many of the general purpose bombs before they're tweaked into a "smart bomb" configuration.

What it means to investors
Gains in the stocks of Boeing and Raytheon -- and elsewhere within the U.S. Aerospace & Defense ETF -- were to be expected in the wake of last Friday's news. That said, it's possible that much of these companies' increased business has now been priced into their stocks, limiting their potential for further gains.

In contrast, as this article went to press, General Dynamics shares were up just 1.7% through Wednesday trading, while Kaman shares had climbed just 1.2% -- both far less than the average gains seen on the U.S. Aerospace & Defense ETF. On the one hand, this is understandable. General Dynamics is generally viewed as a tank maker, while tiny Kaman, at just $1 billion in market cap, is considered a bit of an afterthought among defense investors.

Long story short: Both General Dynamics and Kaman have roles to play in the air war against ISIS. Most investors don't realize that yet. But now you do.

SDB after. Image source: Boeing.