Any discussion of stock strategies should probably start with Eugene Fama - the "father of modern finance" [1] and winner of the Nobel prize for his "empirical analysis of asset prices" [2].
His most famous contribution is proposing the three levels of market efficiency, but this is closely followed by his extension of the single factor model based on the capital asset pricing model to include two additional observations: small firms and firms with high book-to-market ratios tend to outperform the market even after controlling for market risk (β) [3]. a. He actually found results much more impressive than just this, namely [4]:
After controlling for the book-to-market ratio, leverage no longer correlates with higher return
After controlling for market capitalization and the book-to-market ratio, the E/P ratio no longer correlates with higher returns.
After controlling for market capitalization, β no longer correlates with higher returns. In other words, they find the CAPM model to be completely wrong!b
You may think this disproves the CAPM, and I think Fama would agree with you. You may think this disproves the efficient market hypothesis - and there Fama does not: he's pretty adamant that all a paper can do is prove that either the market is not efficient or that the pricing model is wrong, but that it's impossible to prove which is the case. For the skeptical, Fama cites an alternative reason small firms might yield better returns in an efficient market [6]
Is there any criticism of the study itself? I haven't seen any besides the obvious: just because the strategy worked in the past (1963 - 1990 in this case) doesn't mean it works now. If this is true, there are two possible reasons: (a) the market itself changed, presumably getting more efficient over time. and (b) the relationship is statistical luck.
There is some indication of (a): β did predict returns between 1941 and 1965 - but this still goes away after controlling for firm size, suggesting what changed was the relationship between β and firm size, not either of them and returns.
I decided to do some more recent validation using Vanguard ETFs from the early 200s until today.c I found the VSMAX and VXF (indices that tracked small firms) outperformed the wider market by about 0.8% annually, though the t-score was only 0.5.
In my opinion (b) is only plausible for the market capitalization parameter since its p-values ranged from 0.05 to 0.00065. Once you consider all the plausible other parameters that might predict stock trends, this seems plausibly due to chance. The book-to-market ratio's p-values, however, ranged from roughly 1-in-100,000 to roughly 1-in-a-billion, which seems really implausible to be by chance alone.
Other Factor Models
Carhart four-factor model - the Fama-French Three-Factor Model with an additional momentum factor [7]
Fama-French Five Factor Model - the Fama-French Three-Factor Model with two additional factors (robustness of operating profit and investment aggressiveness) [3]