I would also use a recursive named template - but instead of going over each character in text I would iterate on delimiters only:
XSLT 1.0 + EXSLT str:split() extension function
<xsl:stylesheet version="1.0"
xmlns:xsl="http://www.w3.org/1999/XSL/Transform"
xmlns:str="http://exslt.org/strings"
extension-element-prefixes="str">
<xsl:output method="xml" version="1.0" encoding="UTF-8" indent="yes"/>
<xsl:strip-space elements="*"/>
<xsl:param name="text">dInEsh sAchdeV kApil. muk O'connel derrick, Adrian-merriel james</xsl:param>
<xsl:variable name="lower" select="'abcdefghijklmnopqrstuvwxyz'" />
<xsl:variable name="upper" select="'ABCDEFGHIJKLMNOPQRSTUVWXYZ'" />
<xsl:variable name="punc" select="translate($text, concat($lower, upper), '')" />
<xsl:template match="/">
<output>
<xsl:call-template name="capitalize">
<xsl:with-param name="text" select="translate($text, $upper, $lower)"/>
<xsl:with-param name="delimiters" select="translate($text, concat($lower, $upper), '')"/>
</xsl:call-template>
</output>
</xsl:template>
<xsl:template name="capitalize">
<xsl:param name="text"/>
<xsl:param name="delimiters"/>
<xsl:choose>
<xsl:when test="$delimiters">
<xsl:variable name="delimiter" select="substring($delimiters, 1, 1)"/>
<xsl:call-template name="capitalize">
<xsl:with-param name="text">
<xsl:for-each select="str:split($text, $delimiter)">
<xsl:value-of select="translate(substring(., 1, 1), $lower, $upper)"/>
<xsl:value-of select="substring(., 2)"/>
<xsl:if test="position()!=last()">
<xsl:value-of select="$delimiter"/>
</xsl:if>
</xsl:for-each>
</xsl:with-param>
<xsl:with-param name="delimiters" select="translate($delimiters, $delimiter, '')"/>
</xsl:call-template>
</xsl:when>
<xsl:otherwise>
<xsl:value-of select="translate(substring($text, 1, 1), $lower, $upper)"/>
<xsl:value-of select="substring($text, 2)"/>
</xsl:otherwise>
</xsl:choose>
</xsl:template>
</xsl:stylesheet>
Result
<?xml version="1.0" encoding="UTF-8"?>
<output>Dinesh Sachdev Kapil. Muk O'Connel Derrick, Adrian-Merriel James</output>
However, this is not perfect: a sequence of consecutive delimiter character of the same kind will be reduced to a single character - e.g. alpha---bravo
==> Alpha-Bravo
.