>  so I must be doing something horribly wrong

No, I think it's just that nxml mode doesn't read DTD syntax so doesn't
see your entity definition.

is &content; really so much easier to type than 
<xsl:value-of select='.' /> especially when nxml-mode will type almost
all of <xsl:value-of select='.' /> for you automatically with its
auto-completion features?

nxml mode tells me (incorrectly) that

<?xml version="1.0"?>
<!DOCTYPE xsl:stylesheet [
<!ENTITY content="<xsl:value-of select='.' />">
]>
<xsl:stylesheet version="1.0" xmlns:xsl="http://www.w3.org/1999/XSL/Transform">
  <xsl:output method="html" indent="yes" />

<xsl:template name="x">
 &content;
</xsl:template>

</xsl:stylesheet>

is invalid but it is quite polite about it, it's not as if it stops you
saving the ile until the non-existent error is corrected.

David

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