In the past, I've mentioned our eternal efforts to uncover small companies that will eventually appreciate many times in value. The legendary Peter Lynch called such companies "multibaggers," and they are the real difference-makers in a lifetime of investing -- the ones that easily make up for mediocre and failed investments.

Just ask anyone who put $5,000 into Starbucks (NASDAQ:SBUX) 10 years ago -- after the stock had already doubled -- and watched it turn into $52,000. Or how about those who saw the turnaround under way at Lowe's (NYSE:LOW) in 1990, reinvested dividends along the way, and grew $5,000 into more than $100,000? Both of these companies gave hints of a bright future. In Motley Fool Hidden Gems, we look for such unknown or unloved businesses, and even those considered broken by most investors.

Today, I thought it would be interesting to look at Audible (NASDAQ:ADBL), and why it turned into a seven-bagger for me over a relatively short period. It's especially interesting now because since this column first ran about nine months ago, it has taken several big swings. It rose and became my first-ever eight-bagger, but it has since dipped and is now about a five-bagger! That's still an outstanding gain, of course, and perhaps we can learn why, in this short period of time, the stock achieved what it takes an index fund years to reach at historical market growth. We love indexing and think it should be a core part of your portfolio, but Audible offers a great example of how small-cap investing can really juice your returns.

Hear me now
Audible is the No. 1 provider of spoken-word content on the Internet. Besides audio books, it also provides daily newspaper and magazine articles, interesting speeches, and various other nifty things. Users can download the content to listen via encoded MP3 files on their portable player, burn it onto a CD, or just listen on their computer. Think of how handy it would be to listen to The New York Times or The Wall Street Journal on the way to work every morning!

In typical Lynchian fashion, I was a loyal Audible customer before I thought about the company as an investment. I commute to Fool HQ 30 minutes each way, and in 2000 I found that Audible's audio books not only made that time on the Capital Beltway fly by but also educated, amused, and enriched me in ways I would never have imagined.

When I started, a $14.99 monthly fee allowed me to download two books each month. I was able to catch up on things I should have read long ago but never had the time. The Hobbit motivated me to read the entire Lord of the Rings trilogy. Jeffrey DeMunn's narration of Stephen King's Dreamcatcher was outstanding. Ernest Hemingway's The Old Man and the Sea was short but sweet. Atlas Shrugged, Ayn Rand's 55-hour epic, was not short. I would never have discovered such gems as Ender's Game and Life of Pi if it weren't for Audible. All "told," nearly 100 books have passed through my now-ancient Rio 500 MP3 player and into my head.

Barely audible
When I looked at the company as an investment possibility, the stock was below $1 per share, down from the $45 range after its 1999 IPO. The business had never been profitable and was in danger of running out of money and closing its doors. It was too risky for me then, but I kept an eye on it. Over the months, things began to stabilize somewhat. Sales growth, after decelerating from 1999 through 2002, began accelerating again. The stock price doubled from its lows. There were still many obstacles to overcome, but -- because of the strength of the product, high inside ownership, and the dedication of Chairman and CEO Donald Katz -- I believed the company would get past the bad times and flourish.

In September 2003, I bought in at $1.14 per share. This was before I joined the Hidden Gems team and, unbeknownst to me, Tom Gardner placed it on his Hidden Gems Watch List in the October 2003 issue, citing a move toward positive free cash flow, non-dilutive management, top-line growth, and other improving fundamentals.

Since then, we've seen six straight quarters of positive cash from operations, four quarters of GAAP profitability, a reverse stock split (which raised my cost basis to $3.50 per share), a relisting on the Nasdaq, a deal with Apple to get content in the iTunes Music Store and to make the hot-selling iPod players "Audible-ready," and a stock price that has risen some 400%. MP3 players from Creative Technology (NASDAQ:CREAF), SanDisk (NASDAQ:SNDK), and Dell (NASDAQ:DELL) are also showing up everywhere -- and each owner is a potential Audible customer.

Also, investors have come to realize the potential of Audible's distribution system. Netflix CEO Reed Hastings has mentioned Audible as one of the small companies he most admires. I can't help wondering how much more efficient and profitable his business would be if it didn't have to mail out all those DVDs. One day, when broadband becomes even broader and other technology is in place, Netflix and competitors Blockbuster and Wal-Mart will be able to distribute movies the same way Audible offers books. Perhaps Audible, with its first-mover expertise, will even have a hand in it all.

A Gem-dandy
My point here is not to extol the virtues of Audible. It is very volatile and will likely take more wild swings in the future, and is no longer a value play. Don't get me wrong. I believe in the company's vision and will continue to hold all or part of my position for the foreseeable future. Just understand that it's still a high-risk investment.

Instead, I think it's instructive to look back at some of the characteristics that made Audible a Hidden Gem in the first place, a couple of years ago:

  1. After a period of decline, accelerating sales growth.
  2. High inside ownership.
  3. Non-dilutive, shareholder-friendly, dedicated management.
  4. Strong price appreciation potential based on Tom's valuation method.
  5. Underfollowed and unloved.

When we find companies like this at Hidden Gems, we become very interested and dig deeper, making sure that all the pieces of the puzzle fit together. This has led us to outsized gains in Group 1 Software (before it was swallowed by Pitney Bowes), FARO Technologies (NASDAQ:FARO), and many others. All told, our selections are up an average of 36% since the newsletter's inception nearly two years ago, vs. 10% for equal amounts invested in the S&P 500.

If you're interested in our approach and want to receive two stock recommendations each month, Tom is offering a special 30-day free trial.

This column was originally published on Nov. 19, 2004. It has been updated.

Rex Moore is currently listening to The Short Stories of William Somerset Maugham. At the time of publication,he ownedshares of Audible. Netflix and Dell are Motley Fool Stock Advisor recommendations. The Fool has adisclosure policy.