'Mid and small caps 30-50% pricier than historical averages'

Summary: The Indian equity market has been turbulent this year, but valuations in many pockets still look stretched. UTI Mutual Fund’s Sachin Trivedi discusses whether these premiums make sense and if better returns are on the horizon in this interview.

Despite remaining volatile for most part of the year, domestic inflows into equities have stayed strong. Yet, this hasn’t translated into market performance, as companies report muted revenue growth and profits. According to Sachin Trivedi, Senior Vice President, Head of Research and Fund Manager – Equity at UTI Mutual Fund, this trend may persist owing to market consolidation, as well as the fact that many investors may be booking profits due to elevated valuations, particularly in the mid- and small-cap space.

In this conversation, Trivedi, who manages five funds with an asset base of around Rs 14,800 crore at the fund house, explains why mid- and small-cap premiums need to cool off, why his portfolios maintain a quality tilt and the factors behind the strong performance of UTI Balanced Advantage and UTI Transportation and Logistics funds.

The markets have been volatile lately, especially in the mid- and small-cap space, where returns have turned negative over the past year. Despite strong domestic inflows, equities haven't really moved. What do you think is holding them back?

I'll provide some background on earnings, as they are the most important factor from a market perspective. Between FY20 and FY24, if we look solely at the Nifty, we had a compound annual growth rate of 19 per cent in earnings. Last year was a year of consolidation. And if you look at the Bloomberg consensus, this year is also expected to see around 9 per cent earnings growth.

Regarding your point about domestic flows, these flows continue to sustain themselves because, to some extent, investors still consider past returns before allocating their money. A good chunk of this money is also coming through systematic investment plans (SIPs) of mutual funds. Having said that, while there's a large chunk of inflows, there are also pockets of investors — maybe foreign investors or even domestic promoters — who sense that valuations are expensive and are booking profits. So, while there is strong demand, there's a supply as well. Because earnings have consolidated and not performed as strongly as during FY20-24, we are seeing some market consolidation.

If you examine company fundamentals, topline growth has already slowed over the last one-and-a-half to two years. Profit margins had expanded earlier, but now both topline growth and profitability are converging. This is leading to subdued performance, and until we see an improvement on that front, I don't expect markets to deliver very strong returns. The mid- and small-cap segments are also facing similar headwinds.

But with the recent correction, have valuations become meaningfully better, or do you think they're still expensive in certain pockets?

Of course. When discussing valuations, it is essential to consider them from both the P/E and P/B perspectives. In large caps, valuations are still slightly expensive compared to long-term averages, but I wouldn't call them very expensive. The earnings growth momentum, based on Bloomberg consensus or any other parameter, still suggests high single-digit growth.

In mid-cap companies, earnings performance is slightly better, while in small-cap stocks, earnings have moderated quite significantly. But if you look at valuations from a price-to-book perspective, mid- and small-cap indices are currently about 30-50 per cent more expensive than their historical averages.

In the past, it made sense to assign a valuation premium to mid caps compared to large caps. However, now that earnings growth has moderated and, in some cases, even fallen below large-cap levels, I don't see a strong justification for that premium. Eventually, I think valuations will have to align with actual earnings performance.

Let's discuss your approach a bit. How would you describe your overall investing style, and what are the key factors that drive your stock selection across market cycles?

I would describe my investing style as a blend approach, where I look at sectors that have either an earnings tailwind or valuation support. There's definitely some weight given to sector selection. Within those sectors, I try to identify stocks that can deliver the best outcomes.

When you look at the final portfolio, there's a clear quality tilt. Whether it's return ratios or cash flows, you'll find this tilt tends to be positioned in the higher-quality bucket. That said, we're not restricted to only high-growth or premium-quality stocks. We also look for opportunities where there's a balance of value and growth, particularly in companies that can show substantial improvement over the next 24-36 months.

We are also open to turnaround stories and cyclical plays. For example, in certain cyclical sectors where profitability is currently depressed, making valuations appear optically expensive, we try to look beyond the near term and focus on what the business could deliver over the next two to three years. Similarly, we are open to investing in companies that are undergoing positive management changes or strategic realignments.

Overall, I would describe it as a blended approach, combining growth, value and quality, with a consistent tilt toward quality over the long term.

You manage two distinct strategies, the Infrastructure & Transport Fund and the Balanced Advantage Fund. How do you adapt your investing style to each, and what factors remain constant when selecting stocks across market cycles?

Upon examining the approach, whether it's the Balanced Advantage Fund or the Transportation and Logistics Fund, the philosophy remains broadly similar. You'll notice a slightly large-cap bias in both because, as I mentioned earlier, we prefer quality companies and generally look for market leaders within their sectors, along with a growth bias.

However, for the Transportation and Logistics Fund, the investible universe is limited to autos, auto ancillaries and logistics. Here, the focus is on identifying companies likely to gain market share over time. Since the Auto sector is cyclical, we have to be especially cautious about product launch cycles, identifying which companies have new or competitive products and are best positioned to capture market share. These companies typically also enjoy stronger pricing power within their segments.

In the Auto Ancillaries sector, we prefer diversified players, both in terms of product mix and geography, rather than monoline companies. We also look for opportunities that benefit from regulatory tailwinds, such as new safety or feature mandates. For instance, the increasing adoption of ADAS (Advanced Driver Assistance Systems) has opened up new growth opportunities for certain suppliers.

Across all segments, management quality and integrity are critical. We look for promoters and leadership teams that are growth-oriented and long-term focused. And importantly, we try to avoid value traps — companies that appear cheap on valuation or offer high dividend yields but lack visibility into their growth.

The UTI Balanced Advantage Fund has performed well, even in a largely flat market. What were the key calls or allocation shifts that helped you deliver this stability? Additionally, how do you determine the fund's allocation between equity and debt? Is it primarily model-driven, or do you use discretion depending on market conditions?

Let me first explain how we manage the allocation. Since the launch of the fund, our core promise to investors has been to follow a disciplined, valuation-based approach. This means that whenever valuations appear expensive, we reduce our net equity exposure, and when valuations turn attractive, we increase it accordingly.

We follow a proprietary internal model to determine the allocation. This model evaluates four major parameters. Three of them are market-linked, such as the one-year forward price-to-earnings (P/E) ratio, price-to-book ratio and dividend yield. The fourth factor examines the relationship between equity yield and bond yield, helping us assess the relative attractiveness of equities versus fixed income.

All these parameters undergo detailed statistical analysis. In simple terms, when the market appears expensive, we reduce equity exposure, and when valuations become more affordable, we increase our equity allocation.

Over the past year, we made three key allocation changes. In September 2024, when valuations were quite expensive, our net equity allocation stood around 45 per cent. By November, as valuations became relatively reasonable, we increased this to about 55 per cent. Then, in February 2025, amid the global tariff-related noise and market volatility, we further raised our allocation to around 65 per cent, and it has broadly remained at that level since then.

While the model provides weekly signals, we don't act on every fluctuation. We make changes only when the deviation between the model's indication and our current allocation exceeds about 7 per cent. This helps us avoid reacting to short-term volatility and ensures that our decisions remain disciplined and data-driven.

From a performance perspective, both stock selection and sectoral allocation have contributed positively. Our overweight positions in the auto and services-related sectors worked well, and our underweight stance in FMCG and oil & gas also aided performance. On the other hand, we faced some headwinds due to a slight overweight in IT and certain financial stocks, where our selections didn't play out as expected. Nevertheless, overall, the fund delivered satisfactory results, reflecting the effectiveness of our disciplined, valuation-led approach.

The UTI Transportation & Logistics Fund has delivered strong performance even amid sectoral volatility. What, in your view, has driven this resilience, and how do you go about identifying opportunities within such a diverse and cyclical space?

As discussed earlier, the Transportation and Logistics sector is inherently cyclical. However, over a long enough cycle, both in India and globally, the consistent winners tend to be companies that get their product strategy and execution right.

For original equipment manufacturers (OEMs), the product launch cycle is absolutely crucial. Typically, it takes around three to four years for an OEM to develop and launch a new product, from concept to market. So, we closely track which products are likely to be launched and assess their potential success. The success of each product directly impacts a company's pricing power and operating leverage. Essentially, the entire auto ecosystem, from OEMs to suppliers, thrives on the strength and differentiation of these product launches.

In the Indian context, one key trend we've observed is the gradual shift in consumer preference. Entry-level or small cars haven't performed well in recent years, while demand has moved toward SUVs and SUV-like vehicles. So, product portfolios aligned with these evolving trends have a much better chance of success. Alongside this, the capital-allocation discipline of management teams also plays a major role. We look for companies that deploy capital prudently, whether in R&D, capacity expansion or strategic alliances.

When it comes to auto ancillaries, the key is identifying which suppliers are aligned with the winning OEM models rather than simply picking companies in isolation. We also pay attention to their joint ventures and partnerships, especially since India is still in a phase of indigenisation, reducing its dependency on imported components. OEMs are driving this shift, which creates a significant business opportunity for ancillary players that can execute effectively.

However, we are equally mindful of return ratios. Many ancillary companies fall into the trap of constant expansion, leading to equity dilution and depressed returns. We prefer those that manage growth efficiently while maintaining healthy capital efficiency.

In summary, the fund's resilience stems from its focus on management quality, prudent capital allocation, product-cycle positioning and alignment with winning trends. This disciplined framework helps us navigate the sector's cyclical nature and identify opportunities that can sustain performance over the long term.

Also read: Premiums in mid and small caps don't sustain; be cautious: Franklin Templeton's Ajay Argal