'Correction could be more prolonged in mid and small caps'

Summary: Mid- and small-cap valuations have cooled meaningfully after the recent correction. Yet, UTI AMC’s Head of Equity, Ajay Tyagi, believes both segments remain overheated and could see further downside. In this exclusive conversation, he explains why he prefers mid caps over small caps, outlines his quality-growth investing framework and the UTI Focused Fund’s recent improvement in performance.

Mid- and small-cap stocks have seen a sharp correction after a prolonged phase of exuberance, bringing valuations off their peaks. But Ajay Tyagi, Head of Equity at UTI AMC, believes the cooling-off period is not yet complete. While he sees limited downside left in large caps, he feels mid- and small-cap valuations remain overheated. Yet, Tyagi is more comfortable investing in mid-cap stocks, given their relatively stronger business models and better visibility, compared to the higher vulnerability of small-cap businesses.

Presently, Tyagi oversees two schemes with a combined asset value of Rs 30,114 crore at the fund house. In this interview, he also talks about staying true to a quality-growth philosophy, resisting the temptation to rotate styles, why patience and process matter more than short-term performance and the reasons behind the recovery in the UTI Focused Fund’s performance.

After the recent correction, do you think valuations have meaningfully corrected in pockets where excesses had built up, or do you still see a gap between market pricing and earnings visibility in parts of the market?

I would say that while valuations have corrected, there is still room for further correction. Let me break down the market into the traditional buckets of large, mid and small caps. Our view is that, as far as large caps are concerned, they are overvalued, but not by much. Over the next 6-12 months, as earnings grow, valuations for large caps could move closer to their long-term averages. So, the remaining magnitude of correction in large caps is limited.

However, when we look at mid- and small-cap valuations relative to their long-term averages, there is still plenty of room for further declines. I think that’s why we have been cautious about mid- and small-cap stocks, and we have been communicating this to our distributors and advisors: this is the part of the market where the correction could be more prolonged. We continue to hold that view even today.

Mid and small caps have seen a sharp re-rating followed by a correction. How do you assess opportunities in this space today, and where do you see the best balance between growth potential and valuation comfort?

As far as mid and small caps are concerned, we find both segments to be overheated. However, when we look at business models, I would say that mid caps, particularly those covered under the SEBI definition, which broadly includes stocks ranked 101-250, offer much greater comfort in terms of business quality and visibility.

Small caps, as we all know, have very high mortality. While businesses that succeed can do extremely well and deliver exponential returns, one must also appreciate the fact that this segment has a very high failure rate. Now, when valuations are already elevated in the context of what they have been over the last 20 years, it makes more sense to be in a segment where business models offer at least some degree of certainty and, to that extent, a backstop.

So, between mid and small caps, our preference is for mid-cap stocks. Both segments are expensive, but we find business models in mid caps to be more resilient.

You’ve long followed a bottom-up, high-conviction approach focused on quality businesses and long-term compounding. How has this style evolved over time, and what parts of the process become most critical during phases of underperformance?

The process keeps evolving, but certain elements are sacrosanct and never change. Before getting into the quality-growth style specifically, it’s important to highlight how UTI functions as an organisation.

We run multiple funds that follow distinctly different strategies, but we also operate with very clearly defined guardrails. These are meant to provide investors with an understanding of a fund manager's investment style, portfolio construction approach and their consistency over time. We believe such disclosures would help investors remain aligned with the funds' portfolio construction, regardless of market cycles or near-term performance.

What we are extremely conscious of is that once a fund is positioned in a particular manner, whether it is our UTI Flexi Cap Fund, UTI Mid Cap Fund or UTI Large & Mid Cap Fund, we deliver that style consistently and predictably to investors. That discipline remains intact regardless of how market cycles evolve or how short-term performance numbers look.

Coming specifically to the quality-growth style, there are a few non-negotiable tenets. We focus on businesses with strong cash flow generation, robust balance sheets and returns on capital that are significantly higher than their peers. The growth element stems from our preference for businesses with long, secular growth runways rather than those driven by cyclical earnings.

That said, there are opportunities that need to be evaluated on a case-by-case basis. For instance, people often ask how a company like Eternal, which is still loss-making, fits into a quality portfolio. While it is clearly a high-growth business, the question is, how does it qualify as ‘quality’? This is where we go beyond headline numbers and dig deeper into unit economics, examining contribution margins, industry structure and competitive dynamics. In food delivery services, the market has already moved towards a duopoly, and while quick commerce hasn’t yet, it is moving in that direction, which implies potential pricing power over time.

So, while we maintain strict guardrails, we also ensure that what we are buying truly possesses the underlying economic characteristics that define quality, even if those characteristics are not immediately visible in reported numbers.

If you look at the markets over the decade from 2010 to 2020, growth stocks performed extremely well. Subsequently, leadership shifted towards value, and momentum also did well. Don’t you think there comes a time when you need to change gears from high-quality stocks to other styles or sectors, in order to generate better returns for the fund?

The answer to this is no. In hindsight, you can always analyse the market and say that the last four years have been exceptionally strong for the value style, and until last year, momentum also performed very well, while quality was badly pummelled. But all of that is visible only in hindsight.

It is entirely possible that 2026 turns out to be a repeat of what we have seen over the last four years, but it is equally possible that the year sees a massive retracement.

This is exactly what we tell our investors. While they need to diversify their portfolios across market capitalisation and investment styles, if a portfolio manager keeps rotating styles, it becomes extremely difficult to execute consistently. A better solution for investors, in that case, is to choose funds that are managed as blended strategies. At UTI, we do have a few funds that follow a blended approach, where the fund manager is neither at one extreme of quality nor at the other extreme of value.

In such strategies, the portfolio is designed such that the tracking error relative to the benchmark remains relatively low. So, if investors do not want high tracking error or prolonged periods of underperformance, blended strategies are a reasonable option. However, the history and fundamentals of investing also suggest that a high active share increases the likelihood of generating outsized alpha. If you stay very close to the benchmark, you may reduce volatility and tracking error, but you also give up the ability to generate meaningful alpha.

Hence, while it may sound simple in theory to keep rotating styles, in practice, investing does not work that way, and we cannot go against these core principles.

Last time, you spoke about prioritising consistency of philosophy over short-term outcomes, even if that leads to periods of underperformance. With the fund now in a longer phase of relative underperformance, how do you internally evaluate whether the portfolio is still positioned correctly, or changes are required?

Look, the fund's positioning is already decided, so we don’t change it. To give you a backdrop, we have different funds mapped into distinct style buckets and market-cap buckets, and we want that positioning to remain constant. Because if we start challenging the positioning every now and then based on near-term performance, the entire process can get disrupted.

Once the positioning is decided, the next step is to ensure we have the right process to identify stocks that fall within that bucket, for instance, quality and growth in the case of the UTI Flexi Cap Fund, or value in the case of, say, UTI Large & Mid Cap Fund. Those respective processes are followed very assiduously, right down to the smallest or lowest-weighted stock in the portfolio. That discipline does not change.

On reassurance, I would again go back to historical data. You will find that, for any style or market-cap segment, there are periods when performance looks very poor. For example, there have been periods when small caps have delivered negative returns even over a five-year horizon, and that is when investors start questioning whether they should invest in small caps at all. But we also know that from those low points, small caps can deliver exponential returns over the next five years.

The antithesis of that was what we saw around 2024, when small caps delivered such strong five- and 10-year returns that many investors felt small caps should form a much larger part of the portfolio. Similarly, with style factors, there comes a point when a style is beaten down so much that people begin to question whether it is even worth staying with it, and whether it should be diluted or tweaked.

However, the data have consistently shown us that these things rotate. So, as long as you are confident that your process for selecting the right quality and growth stocks is intact, it is better to allow market cycles to play out, remain patient and keep reviewing the portfolio rather than trying to predict when quality will come back into favour or whether the style itself needs to be tweaked.

Two new fund managers have joined the UTI Flexi Cap team. What gaps were you looking to address, and how should investors expect this change to influence portfolio construction and decision-making going forward?

The second part of your question is fairly straightforward; there cannot be any change in the way the fund is managed. What is sacrosanct for us is the style under which each fund is run. That remains unchanged, and therefore, there will be no change in the approach of stock selection or portfolio construction. The fund will continue to follow the same quality and growth framework that I outlined earlier.

If you look more closely at the changes, you would have noticed that Ravi Gupta, the assistant portfolio manager on the fund, moved on after almost 20 years with the organisation. Naturally, that required a replacement. Kamal Gada has joined the team as a co-fund manager. He has been with UTI AMC for 18 years and has spent most of that time as an analyst covering multiple sectors. He is a very capable and experienced hand.

We also decided to further strengthen the team by bringing in Akash Shah, who has been with UTI AMC for slightly over seven years and has developed a strong understanding of the consumer sector. The intent was clearly to strengthen the team, not dilute the focus. At some point, a large strategy like this requires more than one portfolio manager. So, when Ravi moved on, we decided to add depth and continuity.

The UTI Focused Fund saw a noticeable recovery versus the Nifty 500 in 2025. What were the key factors behind this turnaround, and what lessons, if any, carry over to other strategies?

Every year, you will see one fund doing exceptionally well, almost beating the lights out, and it is entirely possible that the same fund may have been in the third quartile the year before. But that is not how we look at performance.

As I’ve been saying throughout this conversation, we are extremely process-oriented. We operate within clearly defined guardrails and well-articulated strategies. Over the last few years, we have invested significantly in expanding our research team. Our investible universe today is over 450 stocks, up from around 350 three years ago. In a way, we aim to provide our portfolio managers with a sufficiently wide universe of stocks to select from, while ensuring they remain true to their mandate and strategy.

Portfolio managers may go through phases of pain, but if they remain committed to their process, sharp recoveries do follow. The UTI Focused Fund is a case in point. It reinforces our conviction that one should not make too many changes. Stay the course. If there are mistakes, they should be addressed, but those mistakes are usually related to getting a business call wrong, such as misjudging competitive dynamics, margin sustainability, capital efficiency or the underlying economics of a business.

Beyond that, if a stock underperforms for a few years but the fundamental thesis remains intact, and the original hypothesis is playing out, it is important to stay put. Markets have a way of correcting these phases of underperformance over time. That is the discipline we follow and train our portfolio managers to follow. In that sense, the turnaround of the UTI Focused Fund once again underscores the importance of staying the course, as market sentiment can change quickly.

Also read: Even after the correction, mid and small caps aren't cheap: Axis Mutual Fund's Shreyas Devalkar