Hey, We Just Fly the Planes

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The Alien Tort Claims Act may sound as if it's intended to regulate the intergalactic pastry business, but it's actually used in U.S. courts to litigate charges of serious human rights abuses that occur abroad. Such charges are heavy, and as an investor, it's one of the last things you want in your company's headlines.

Over the past 20 years or so, the act, or the ATCA, has been used in litigation involving firms such as Royal Dutch Shell (NYSE: RDS-B) and Unocal (now a part of Chevron (NYSE: CVX)) that alleges complicity in the hangings of activists and the enslavement of laborers, respectively, at the hands of foreign militaries. A Boeing (NYSE: BA) subsidiary now faces an ATCA charge of providing logistics for CIA operations that whisked off three terrorism suspects to countries with, shall we say, permissive attitudes about interrogating detainees.

The punitive results of such trials have been mixed, but the risk to the reputation of a multinational firm facing an ATCA charge far outweighs any direct monetary damages. The Bush administration, and particularly the embattled attorney general, has proven rather unmoved by the torture status quo. For that reason, activists appear to have shifted the pressure toward private contractors. Ideally, such a looming PR nightmare would cause firms to monitor their potential complicity in abuses much more closely.

The takeaway here is not that market participants may be overlooking the business risks to government contract work. On the contrary, I think such risks are perennially priced into the shares of companies such as SAIC (NYSE: SAI) and Raytheon (NYSE: RTN). It's important for investors who may be new to the sector to recognize why these firms tend to show up in the bargain bin.

Perceived ATCA liability is just one of many considerations weighing on the valuations of contractors. The argument can certainly be made that aversion to the sector has and will continue to provide an avenue for opportunistic investors to outperform the broader market. After all, defense contractors like Lockheed Martin (NYSE: LMT) and General Dynamics (NYSE: GD) typically generate strong returns on capital, and are priced pretty cheap relative to earnings. Only after you recognize the reasons for such discounting, however, can you properly assess whether negative sentiment has created mispricing.

For related Foolishness:

• Cowboys and Indians
• General Dynamics Goes to School
• Raytheon Swimming in Cash

Fool contributor Toby Shute doesn't own shares in any company mentioned. SAIC is an Inside Value recommendation. There's nothing obsolete or quaint about The Motley Fool's disclosure policy.