NEW YORK (TheStreet) -- Joel Greenblatt created a splash when he published The Little Book that Beats the Market, in 2005. Providing a simple guide to buying low-priced stocks, the book was a bestseller and attracted a legion of followers. A host of Web sites began tracking Greenblatt's system.The approach calls for buying 30 undervalued stocks and holding them for a year. While the strategy is simple, it comes with a catch. As Greenblatt outlines in the book, unloved stocks can be volatile. In bad years, the system can drop sharply, and there have been long periods when the stocks lagged the market. Greenblatt argues that his value stocks can produce huge gains over time -- but only for investors with the patience to hold on for years. Now Greenblatt has introduced four mutual funds that roughly track his system. But instead of holding only 30 stocks, the portfolios include many more names. Formula Investing U.S. Value 1000 ( FVVAX) has 800 to 1,000 stocks, while Formula Investing International Value 400 ( FNVAX) has 300 to 500. The greater diversification insures that the funds will be less volatile -- and less likely to trail the benchmarks by large amounts in bad years. Formula Investing U.S. Value Select ( FNSAX) and Formula Investing International Value Select ( FNAAX) are the remaining two, which invest in about 100 stocks each. Greenblatt has watered down the system to make it easier for shareholders to stay with the funds for the long term. He recognizes an unfortunate reality: Many investors panic and dump their funds at market bottoms. The problem is especially acute for deep-value funds. Those tend to be volatile, periodically showing big gains and steep losses. All too often, shareholders buy volatile funds after they have experienced several years of outsized gains -- just before the inevitable downturns occur. Can the new funds match the performance of Greenblatt's original system? Probably not, concedes Blake Darcy, chief executive of Gotham Asset Management, which owns the funds. Over the long term, the funds are likely to deliver slightly lower returns with less volatility. "It doesn't do any good to have great performance if all the investors give up at the wrong time," he says. Investors who prefer using the original formula can pay Gotham Asset a 1% annual fee for a private account that tracks the system. You can avoid the fee by following the system on your own. To do that, you start by ranking the 3,500 largest stocks according to their profitability. The stock with the highest return on capital is ranked number one. The second best is number two. Then you rank all the stocks according to their valuation as measured by a figure known as the earnings yield. This is similar to the inverse of the price-earnings ratio. To measure earnings yield, Greenblatt takes operating earnings and divides the figure by the total value of a company's stock and bonds. A stock with relatively hefty earnings and a small market value would be considered cheap.
After determining the rankings for profitability and price, you add the two figures together, and pick the 30 companies with the best total scores. The resulting stocks may be true gems, extremely profitable companies with low prices. To help you pick the stocks, Greenblatt offers free screens on magicformulainvesting.com. The names in the listings include companies with publicized troubles and low price-earnings ratios. Among the holdings is H&R Block ( HRB). While it has been losing market share to cheap online tax preparers, the company still has fat profit margins. Another holding is Apollo Group ( APOL), a for-profit education company. The stock has been hurt since Congressional critics began threatening to reduce funding for the student loans that cover tuition costs. Other unloved names on the list include tobacco company Lorillard ( LO) and Deluxe ( DLX), which supplies printed material and checks to small businesses, a group that has been hard hit by the sluggish economy. While the list can serve as a source of investment ideas, investors should tread carefully. Many unloved stocks never emerge from the cellar. Stocks that do rebound can take years to deliver big returns. That's why value stocks are not suitable for the weak-kneed and those who seek quick results.